Distressed debt investors may cheer forecasts of increasing bond defaults, but higher prices mean it is tougher for companies to make money. Professor Edward Altman, director of credit and debt markets research at the New York University Salomon Center, Stern School of Business, predicts bond defaults will increase. But he added that the large amount of liquidity in the market has driven up prices and made it more difficult for distressed debt investors to score good returns.
The average price on defaulted bonds this year is 60 cents on the dollar. In 2001 and 2002, the average defaulted bond sold at 25 cents on the dollar. "Today it is a tougher market to make money in for distressed debt investors compared to when the average recovery price was 25 cents on the dollar," he said. "The average recovery rate should have been 45 cents on the dollar, but it is 60. One reason is the tremendous increase in players in the market," said Altman. He estimates between $150-200 billion of money is dedicated to distressed debt investing. This does not count private equity money.
Altman predicts the default rate at the end of this year will be 3%, up from 1.24% last year. The historical average of default rates is 5%. This year's default rate is still much lower than the 12.8% high it reached in 2002. Altman predicts that next year the default rate will be 4.7% and that in 2007 it will reach more than 5%, but less than 10%. He cites the increase in the high level of debt to equity financing of leveraged buyouts, a big number of ailing industries and a large number of new issue in the past two years that is rated B minus or lower. He said that many issues rated in this category tend to default in the second and third year after issuance.