Edward Altman, professor of finance at the Stern School of Business, New York University, predicted the end of the benign credit cycle with higher default rates in the public securities market expected this year and next. Altman predicted a 4-4.25% default rate in 2006 and more than a 5% default rate for 2007. He said this is partly driven by leveraged buyout financing, which has increased companies debt to EBITDA ratios. The size of the U.S. high-yield bond market reached a record high of $1,073 billion in 2005. Last year, the default rate in the bond market was 3.37% and it was 1.25% in 2004. Altman pointed out that last year was characterized by a small number of large bankruptcies.
Altman said the possible defaults of General Motors and Ford Motor constitute wildcards in his default loss predictions. He said that the credit default swap market currently predicts a 23% probability of default for GM within one year, and a 73% probability within five years. This compares with his prediction of a 15% probability of default for GM within one year, and a 70% chance of default within five years.
An increasing trend is the higher recovery rates of defaulted bonds. Last year, the recovery rate on senior secured bonds was $76.5 compared with $52.81 in 2002. The recovery rate for senior unsecured bonds in 2005 was $45.88, compared with $21.82 in 2002. "It is a new paradigm that recovery rates are higher because of the amount of cash out there," said Altman.
The size of the private distressed debt market continues to exceed the size of the public distressed debt market. In 2005, the private market for distressed debt had a face value of $111.3 billion compared to $80.6 billion in 2004. This compares to $50.6 billion of distressed debt in the public bond market in 2005, compared with $36.6 billion in 2004. The face value of private defaulted debt in 2005 was $374.9 billion, compared with $334.4 billion in 2004. By comparison, the face value of defaulted public debt in 2005 was $170.4 billion, compared with $152 billion in 2004.