“If 2008 was the year of systemic risk… 2009 seems likely to be a year dominated by a specific risk,” says The Economist. “In other words, we can be sure that more companies will default on their debts.” Default rates on high-yield (i.e. riskier or ‘junk’) bonds in America are less than 4%, but this is set to rise sharply as the economy worsens and overstretched borrowers get into trouble – Barclays Capital is predicting a default rate of 14.3% in the second half of 2009. Since lending standards in this credit boom were relaxed like never before, much of the outstanding bonds and loans are “the junkiest junk in history”, as Edward Chancellor, now of GMO, once dubbed it. Normal trends may not apply – high-yield recovery rates (the amount of principal that investors get back when a bond defaults) on high-yield bonds that default are likely to be 10%-20% compared with the 40% expected normally, says Citigroup. Leveraged loans – the loan equivalent of a junk bond – are likely to recover 45%-60%, against 70% normally.
This credit cycle may be worse in other ways, adds Morgan Stanley. American companies in trouble can file for Chapter 11 bankruptcy, in which they restructure debts and try to become viable again. To do this, they usually secure debtor-in-possession (DIP) financing, which helps fund the company through this process – but the reluctance of banks to lend means financing is hard to come by. This is likely to encourage firms to file for bankruptcy earlier than usual, before they exhaust their cash reserves, or – if they lack the cash to do this – oblige them to liquidate rather than file for Chapter 11, increasing job losses and further reducing recovery rates for investors, says Yves Smith on Nakedcapitalism.com.