Moody's says defaults will peak this year, but distressed debt investors say the default trend has only just begun. Writer Suzanne Miller

Jason Mudrick interrupts his telephone conversation a third time to shout out an order. His other line rings again - and again. In between bellowing orders for deals and conversing, he is scouring a database of 600 companies that he is betting will go bust. Mr Mudrick runs Mudrick Capital Management, a hedge fund that focuses on distressed debt - one of legions launched this year.

He calls his list "zombie companies - the walking dead" that are "prospectively in default", but are delaying doomsday by extending maturities and buying bonds back on the open market. He says that these companies have a 60% chance of filing for bankruptcy over the next five years.

Everywhere, yield-hungry investors are gathering for distressed opportunities among companies that are struggling to emerge from the 2008 credit crisis and prior years of leveraged exuberance. Over the past year, an estimated $300bn of new money has poured into high-yield funds. "The size of the US high-yield cash market is just $1000bn, so that is driven spreads very tight because these funds are paid to be fully invested," says Mr Mudrick.

Corporate bond spreads have snapped in like rubber bands from last year's historically wide levels. The average investment-grade credit spread has tightened some 300 basis points (bps) in the year to date until October to 192bps, while the average high-yield spread has tightened by 1014bps to 798bps, according to Barclays and Merrill Lynch data. While still wider than historical levels, the extent of the contraction suggests that investors feel much more relaxed about credit risk these days. And if forecasters such as Moody's Investors Service are right, global speculative-grade default rates will peak this year at 12.4% and then drop down to single digits next year, resuming to a relatively normal level. Or will they?

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Peter M. Lupoff, founder, CEO of Tiburon Capital Management

Bubble ripe for bursting

Market veterans who have lived through distressed cycles since the early 1990s believe that the worst is yet to come. "I would say this market looks like it is still in a bubble; we've just replaced one asset bubble with another," says Peter Lupoff, who late this year launched Tiburon Capital Management, a hedge fund specialising in distressed debt. "Company performance doesn't support many current valuations when most of it has been driven by cost cutting," he says.

That could mean one thing: plenty of defaults down the line. According to Credit Suisse data, about $1000bn in leveraged-loan and high-yield maturities is due to mature in the next five years. But some warn that current leverage levels remain so high that it could be prohibitively expensive for these companies to refinance - leading to more defaults.

"I think fixed income across the yield curve is going to be distressed. There's a huge bull market in complacency right now," says Michael Pento, chief economist at money management firm Delta Global Advisors.

Pablo Mazzini, an analyst at Fitch Ratings in London, says Europe also needs to refinance a mountain of high-yield debt, especially leveraged loans - more than €200bn in senior secured debt - by 2016. In the case of distressed loans, lenders have opted to put firms up for sale or spin off assets to extract value, for the simple reason that there have not been any buyers so far. "This is why we saw numerous instances of 'consensual' debt restructurings instead, whereby all lenders agree on the appropriate level of debt capacity by accepting a partial write-off while rolling over their remaining exposure," he says.

Banks have had little choice but to keep these companies alive, he says, as loan documentation at the top of the market was very loose, compounded by the complexity of legal regimes in Europe and lack of strategic buyers who would match the price that senior lenders could hope to obtain to get their claims covered in full. "Companies are accepting write-offs and securities such as payment-in-kind notes that add to [their] debt levels in the hope that conditions improve enough for them to exit. These are not realised recoveries. So it is very hard for investors to see what their real level of recovery will be. That is yet to be determined," says Mr Mazzini.

Distressed debt levels, 2006-Q2 to 2009

Distressed debt levels, 2006-Q2 to 2009

Bloodbath for investors?

If and when company defaults accelerate, some suggest there is going to be plenty of pain to go around. Mr Mudrick warns that investors who have poured money into leveraged funds could be hit especially hard if his default predications materialise. "High-yield funds can't hold defaulted debt. I think there is going to be a blood bath among these retail investors - and little do they know," he says.

Life is already proving trying for traditional unsecured and subordinated bondholders. Distressed debt specialists say recovery rates will be significantly lower for them this time around, reflected to some extent by prices in the secondary market, where bonds for a number of distressed companies are trading for pennies on the dollar. For example, the subordinated debt of CIT Group - the lender to small and medium-sized businesses that filed for bankruptcy protection in November with $30bn in debt - traded at six cents on the dollar in the same month.

Marty Fridson, former head of the junk-bond research desk at Merrill Lynch and now CEO of Fridson Investment Advisors, an investment management firm, says that recovery values - what bondholders hope to get when a company's debt is restructured - is at cyclical lows of 20 cents on the dollar, compared with a moving average of 40 to 45 cents. "Recoveries are somewhat lower than troughs in the past couple of cycles," he says.

That is largely because bondholders have been squashed down the capital structure as higher-than-normal secured debt levels pile on top of them - due to the rise of collateralised loan obligations (CLOs) and collateralised debt obligations (CDOs). "What would ordinarily have been financed in bonds was done in loans to feed the CDOs and unattractively priced to the lenders," says Mr Fridson.

Kenneth Emery, director of corporate default research at Moody's Investors Service, says this is a new feature. "One thing that we saw, leading up to this cycle, is an increased use of loans, which were very popular in 2006 and 2007. They were cheap, relative to bonds, so companies increasingly used these in their capital structures."

Many of these loans were held by CLOs, securities that are backed by loans and which are now a larger part of the capital structure. Leading up to this recession, loans comprised about 75% of total debt for the average rated US speculative-grade issuer, compared with a more traditional 60%.

Furthermore, CLOs were all too happy to accept lower yields and lighter covenants than banks have traditionally negotiated, because they warehouse securities and parcel them out to investors. That means many have been more focused on volume than yield and they also tend to negotiate with agendas that differ from bank-debt holders. For instance, many are restricted from holding stock, so they often gun for more debt - to the potential detriment of the company.

One bank-debt holder says he knows of a company that is trying to work on a restructuring in which a CLO is pushing to add between $300m and $400m more in debt to the capital structure than the company considers is prudent. The bank-debt holder says the additional debt would make the stock "worthless". But this is a non-issue for CLOs because they do not stock.

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Jason Mudrick, CEO of Mudrick Capital Management

Bondholder haircuts

Bondholders are also facing bigger price 'haircuts' where companies are offering distressed debt exchanges - a growing trend that reflects the lack of capital resources such as debtor-in-possession financing - loans that US banks traditionally extend to companies to allow them to restructure under Chapter 11 of the US bankruptcy code. In the absence of these facilities, companies are trying to reduce debt through these exchanges.

In an investment note, Mark Kiesel, global head of corporate bond portfolios at Pacific Investment Management Co, the manager of the world's biggest bond fund, said of these exchanges: "The investors are typically forced into making a concession by taking a price 'haircut'. Including distressed debt exchanges, the high-yield default rate is already approaching 10%, so the potential impairment to bondholders is pretty onerous in these highly leveraged cyclical companies."

Overall, specialists say workouts have become a lot more complicated than in the past, making it more challenging to make money in distressed debt. Tiburon's Mr Lupoff says that this distressed debt cycle is very different from what it was in the early 1990s, when "you never had the inter-credit issues that you have today". He says there are new classes of creditors that far outnumber the handful of banks that sat around the workout tables in years past. Workouts were done more quickly and transparently. "Today there's a geometry of credit default swap holders that are not a matter of public record, so it is not easy to glean positions and handicap outcomes," he says. "There are a broader range of outcomes than in the past."

The ultimate outcome that Mr Lupoff and his distressed debt counterparts are banking on is the other side of default and a cascade of opportunities that he expects to find, particularly in loans, which he believes will deliver especially attractive returns. He says: "If I am right and there is a correction, I will get another bite of the apple in the loan market." He is one of many waiting for the rotten fruit to fall.

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