Distressed Debt Ratios Jump

Todd Harrison is talking about Distressed Debt Ratios today on Minyanville. Let's tune in.

Snaps to a savvy distressed debt investor Minyan for pointing out that according to Standard and Poor's, the U.S. distressed debt ratio jumped to 11.1% in January, up from 6.1% in December.

What's the distressed debt ratio? It measures the percentage of corporate bonds trading at more than 1,000 bps higher than Treasuries of similar durations. As Mr. Practical noted this morning, debt investors are demanding a higher return for the increasing risk of default.

According to S&P, default rates typically peak one year after the distress ratio does.

Distressed debt investors look to buy debt on the cheap before or during bankruptcy proceedings and sell it post-restructuring or convert it into equity in the new company.

Higher borrowing costs squeeze margins, pushing up defaults, increasing borrowing costs, pushing up defaults. So it goes.

Attention Vulture Shoppers: Debt Is Now On Sale

The Wall Street Journal is reporting Debt Is Now On Sale.

A cottage industry of distressed-debt funds and bankruptcy advisers has expanded in the past two years in preparation for a what they expected would be a wave of distressed debt and bankruptcy filings. So far, they have been twiddling their fingers as companies loaded up with debt. Now, from their perspective, things are looking up.

That is because the distress ratio hit 11% in January, the highest level since September 2003, according to Standard & Poor’s analyst Diane Vazza. The distress ratio is the percentage of bonds trading at junk-bond levels and priced about 10 percentage points more than Treasurys.

In December, the distressed ratio was only around 6%, which makes the increase through this month the fastest recorded since the dark days of October 2002, Vazza said. Distressed issues cumulatively affected $64.5 billion of debt, or more than double the amount in December. More than one-fifth of all the distressed debt came from the media-and-entertainment sector, and one-eighth came from–little surprise here–the financial sector.

Here is what Vazza makes of the trend: “A rising distress ratio signals an increased need for capital and could act as a precursor to more defaults if accompanied by a market disruption.”

That probably means that bankruptcy is back. It definitely means that all those distressed-debt investors should soon have less time for the golf course.

Bankruptcy Is Certainly Back

The city of Vallejo California Is On Brink Of Bankruptcy.
Personal, corporate, and even involuntary hedge fund bankruptcies are making the news. A Boom In Bankruptcies has just started. There is no end in sight.

CDX Spreads Widen

Here's what Mr. Practical has to say about widening CDX spreads today:

This morning, little beknownst to daily stock traders, CDX (asset-backed debt spreads) have widened a dramatic 20 basis points from 145 over treasuries to 165 over.

This is deflation at work, sucking liquidity out of the system. It is the result of banks once again (and again, and again) rejiggering their correlation default assumptions. In order for this to happen, many single name credits have to widen by 70 basis points or more.

This is the normal process of debt contraction. Equities are still asleep at the switch as to the implications: contracting credit equals lower liquidity equals lower asset prices as the debt bubble continues to unwind.

We are still very early in the process despite what government officials and market pundits tell us on TV.

Risk is high.

Corporate Bond Risk Soars

Bloomberg is reporting Corporate Bond Risk Soars to Record on CDO Loss Speculation.

The cost of protecting corporate bonds from default soared to a record as investors purchased credit-default swaps to hedge against mounting losses in the $2 trillion market for collateralized debt obligations.

"The market is full of rumors of unwinding of CDOs, and the price action suggests that people believe the rumors," said Peter Duenas-Brckovitch, head of European credit trading at Lehman Brothers Holdings Inc. in London. "It sort of has that Armageddon feel, and the market is feeding on itself."

Securities known as constant proportion debt obligations (CPDOs) that package indexes of credit-default swaps may be forced to unwind about $44 billion of assets because of a decline in the value of their holdings, UniCredit SpA analyst Tim Brunne in Munich said today. The ratings of 28 CPDOs arranged by banks including ABN Amro Holding NV and Lehman Brothers Holdings Inc. were cut by Standard & Poor's today because they may not be able to cover future interest payments.

CPDOs may have bought as much as $30 billion of credit default swap contracts to hedge against losses on their investments, JPMorgan analysts led by Jonny Goulden said in a note to investors today. "We expect further downgrades from rating agencies, which could lead investors to accelerate closing CPDO positions," the note said.

"Different CPDOs have different trigger levels, but once one is triggered the negative technical pressure that is created may well cause other triggers to be hit," Willem Sels, a credit analyst at Dresdner Kleinwort in London, said in note to investors today.

Banks may unwind CPDOs by buying credit-default swap indexes to offset their bets, driving the indexes higher. The $44 billion of unwind's calculated by UniCredit's Brunne is based on ABN Amro's Surf deal which leveraged its original 2 billion-euro ($2.9 billion) investment as much as 15 times.

"What seems to be clear in both Europe and the U.S. is that the continued unwind of leverage and structured products has continued to lead to underperformance in investment grade," Nick Burns, a London-based credit strategist at Deutsche Bank, wrote in a note today.

There is a stunning ability for the equity markets to shake off bad news after bad news. Meanwhile the underlying credit markets continue to deteriorate. Both cannot be correct. This divergence will end, we just do not know when. The odds are overwhelming that the credits markets have this correct.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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