As with wine, the structure of a loan will depend on the year it was created. Some loans have more generous terms for borrowers, for example, reflecting the higher appetite for risk that permeated the financial world at the time. Others will be more harsh in their flavours, a function of tighter credit conditions.
In any case, Commerzbank/Dresdner’s credit team have an interesting analysis of leveraged loan vintages out this Monday morning, while making the case that corporate defaults are in for something of a sudden acceleration:
A final argument for an acceleration of defaults is the likelihood that the 2006-07 vintages (and maybe the 2008 vintage in Europe) have seen unsustainably low defaults. We think that defaults on these vintages will accelerate, to reach five-year cumulative default rates that are more in line with their low quality. We explain this argument through a cohort analysis.
That analysis produces this chart, which shows cumulative defaults for US levered loans by year of initiation of the loan, or vintage, against time since initiation. In otherwords, it not only shows whether defaults are high or low (y-axis), but also whether they occur early or late in the life of the loan (x-axis):
Commerzbank/Dresdner note that the early default experience of each vintage seems to be largely a function of the risk appetite when the loan was structured, while the longer-term default experience is more a function of the quality of the loan and the economic environment. For example:
…the early defaults of the 2006-07 vintages are well below the average of the other vintages, and this in spite of the fact that they have some of the highest leverage and poorest liquidity metrics. This is to a large extent due to the weak covenants, to which investors were willing to agree because risk appetite was so high at the time.
As suggested earlier, these covenants only allow for a stay of execution. That is clearly evident when one looks at the almost parallel increase of the defaults in the 1997-2000 vintages when the economy decelerated in the year 2001, as indicated by the segments that we have circled. After the initial ‘stay of execution’, the increase of the default rate is largely driven by a weakening economic environment or an aggregate decline in risk appetite, affecting many companies without much (enough?) discrimination on the basis of quality, in our view.
So the analysis gives impetus to the notion that corporate defaults are on their way up — and rather spectacularly at that. Loans started during 2006 or 2007, when risk premia was high and lending criteria low, will accelerate to reach five-year cumulative default rates more in line with the poorer quality of the loans.
As discussed earlier, a sudden surge in leveraged-loan defaults could have massive implications for banks – the key financers of the leveraged buyout boom. It could also though, rebound to other financial service sector investors, such as insurers or pension funds, who in recent times were especially big buyers of structured paper backed by leveraged loans.
There is a bit of good news, however:
But quality tends to win in the end. The five-year cumulative default rate is clearly highest for the vintages with the poorest initial credit quality, such as 1997-2000. The correlation between five-year defaults and leverage or liquidity is a relatively close one, even on an aggregated basis, while it is much lower for two- or three-year cumulative defaults. Therefore, buy and hold investors in particular should eventually win by looking for quality, even if in the shorter term, they might be frustrated by the likelihood that defaults of both bad and better quality loans rise together.
Related links:
Corporate credit, the pachydermic herd in the room – FT Alphaville
SELL: insurers – FT Alphaville