Tuesday 05 June 2018 by Thomas Jacquot Company research

A default is just the beginning – three case studies to illustrate some of the many possibilities

According to credit rating agencies, a wide range of scenarios would lead to a default, even when a company continues to service its debt as originally scheduled

beginning

Fixed income instruments, such as bonds, generally provide a known ongoing return (the coupon) and generally preserve capital (principal). While this is the case in the majority of scenarios, companies will at times come under sufficient pressure that they have to renege on their contractual obligations. The simplest of these scenarios will be a company filing for bankruptcy and therefore stopping payment of interest. In this case, investors would suffer a loss, in so far as they were expecting an interest payment that doesn’t eventuate.

While a non-payment would be a clear default from a rating agency perspective, this is not the only scenario that the rating agencies would consider a default. They consider that a default occurs when a company has breached its promise in relation to an instrument – this is a much wider definition than just a simple non-payment. For example, a company might negotiate with its noteholders to extend the date of final repayment by one year with no change in the interest rate. This amendment would typically be considered a default, even though there might not be any capital loss. Going into administration would also be considered a default by a rating agency, even if the coupon and principal is paid as expected.

It is also important to note that the probability of an instrument defaulting should always be considered alongside the expected loss of capital in the event of a default. Let’s look at the example highlighted above of the maturity date extension: this option tends to be considered by companies under stress, i.e. usually those rated B- or below. According to published statistics by rating agencies, the probability of default for a B- entity over a 12-month horizon is about 7.5%. This probability would increase to about 26% for entities rated lower than B-. Clearly, these are relatively high probabilities that investors need to consider. However, in that particular scenario, there would not be any capital loss.

Let’s take a look at recent examples where rating agencies have considered that a default occurred.

Barminco

Barminco is an Australian mining services company. In late 2015 and early 2016, the mining services sector was under stress because of fall in commodity prices. Given market conditions at the time, Barminco undertook several partial buybacks of its debt on market at levels below face value. The company at the time took the opportunity to utilise cash on balance sheet to reduce its debt (if a bond is bought back at 80% of face value, the company would retire $100 of debt utilising only $80, thereby adding $20 to its equity base). The rating agencies considered this buyback a default. Investors that sold their bonds would have potentially suffered a loss (assuming they had bought the bonds at a higher price) but this was their decision to sell and crystallise any potential loss. Any investors that held onto their bonds did not however suffer any loss of either interest or capital.

Atlas Iron

Atlas Iron is a mining company operating in the Pilbara region of Western Australia. In the face of iron ore prices dropping from $120 to below $60, the company came under significant pressure and proposed, in late 2015, to restructure its debt. This was completed in mid-2016. As part of the restructure, the USD256m of debt was reduced to USD135m, with investors receiving in return about 70% of the shares in the company. The value of the shares at the time of the exchange was about USD72m, meaning that investors suffered an immediate loss of 19% of their capital, assuming they sold their shares immediately. However, for any investors that retain the shares, the combination of the lower bonds and shares would have a value today of about USD280m, or USD24m more than the original bonds due to share price appreciation. In fact, as the share price peaked in early 2017, the bond and share combination would have been valued at about USD375m.

Emeco

Emeco is an Australian rental equipment company. In late 2015 and early 2016, Emeco’s financial position started to materially deteriorate due to the downturn in the mining sector. In September 2016, Emeco proposed to restructure its debt, together with the merger with Orionstone and Andy’s (both companies are also in the rental equipment sector). The scheme, which was implemented in March 2017, provided for the exchange of the USD283m (AUD370m) notes for a new debt instrument and a 31% equity interest in the expanded group. The face value of the new instrument was about AUD300m available for Emeco noteholders. Upon completion, the equity interest had a value of about AUD63m meaning a recovery of 98%. Any noteholders that would have kept their shares would have seen the value of their shares rise to about AUD270m (on a pro rata basis of their ownership) currently, representing an upside of AUD200m. As an alternative, Emeco offered at the time of the merger an option for noteholders to exchange their debt for a cash payment equal to 50% of the face value of their holdings.

Ultimately, investing in high yield bonds has risks which are reflected in the significantly higher yields offered compared to investment grade securities. The higher risk and higher return reflects the higher probability of a default. However, as demonstrated above, not all defaults result in capital loss and, in fact, a high position in a company’s capital structure (as would be the case for a senior secured debt tranche) provides comfort that, in the event of a restructuring, the interest of noteholders will come ahead of other subordinated creditors and shareholders which could result in little or no capital loss. It should be noted that the above examples are for some of the most recent defaults experienced in Australia. As a general rule, market participants believe that recovery on senior unsecured debt would generally average about 40%, with the recovery increasing to about 70% to 80% for senior secured position.

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