Deals that were underpriced this year or have weak covenants will haunt lenders in 2006 as companies become more vulnerable to default on the back of rising interest rates, market participants said. Many distressed companies have been kept out of bankruptcy because they have been able to obtain easy financing from lenders. But these companies may find it hard to weather the higher interest rates that are expected in 2006. Some players said the generous financing that these companies have obtained will hurt lenders because recoveries will not be as high as they expected.
Maria Boyazny, principal at private equity firm Siguler Guff & Company, said second-lien deals in particular will be tested because many lack adequate covenants. She also expects bankruptcies to be more complicated because of the large number of lenders that have taken positions in distressed credits.
"CLOs, CDOs and hedge funds have become the new lenders. Some went way beyond their expertise. They underpriced risk, especially on second-lien paper. This paper has not been tested in bankruptcy," Boyazny said. "For some of these deals, the second liens are junk bonds in disguise, but the investors get paid only a senior-secured rate of return. These players are not familiar with bankruptcy. Because there are more participants, there will be protracted restructurings. A lot will wonder how long they can hold on to a marked-down position. Some will just cut their losses. There will be massive selling."
Some investors believe lenders may tighten up covenants in 2006 to make up for the lax financing of distressed credits. David Breazzano, chief investment officer at distressed debt firm DDJ Capital Management, expects there will be more focus on structuring deals with improved protections. "When situations come into trouble next year, some deals that do not have good documentation will scare people. It will cause more focus on documentation," he said.
Despite the risk that deals that have been poorly structured and priced will blow up in 2006, market participants said distressed companies will continue to obtain easy financing. "There will be plenty of additional liquidity for distressed credits and more product for distressed investors," said Don Pollard, global co-head of leveraged finance at Credit Suisse First Boston. "We will continue to see increased demand for credit from the banks. We will also see additional money raised in the CLO market," he added.
Pollard predicts the second-lien loan market will continue to grow next year, despite second-lien deals trading down in the secondary market. "The market widened out a bit over the past few months. It affected secondary levels on second-lien deals brought in the earlier part of the year. Nevertheless, we think the second-lien market is here to stay. The demand is quite deep," said Pollard.
The airline and auto sectors are expected to continue to be typical distressed credits in 2006. The auto parts sector in particular will be hit, said observers. "Larger OEMS [original equipment manufacturers] will still have problems that will extend into 2006," said Breazzano. Others expect high oil prices to hurt commodity industries, such as packaging. Energy companies are also expected to be at continued risk of default.
The large amount of capital available to distressed companies has pushed up the trading levels of distressed debt to record highs for some credits this year. Some believe distressed debt names will continue to trade at high levels, though the higher default rate may push trading levels down slightly. Breazzano said market conditions may turn soon. "Prices of distressed paper have been higher than average," he said. "At some point this will switch over. We are getting close to it."