Recovery rates on leveraged loans (often used to fund leveraged buyouts) have been less than 25 percent, compared to historical average recovery rates greater than 80 percent (see WSJ article).

Source: WSJ article image, Moody's Investor Service data

Given the recession and recent credit problems in the market, increased defaults are to be expected from companies with high debt and falling revenues, yet there appears to be more to the story. As is typically the case when a company defaults, those at the bottom of the debt food-chain, such as those holding senior unsecured bonds and subordinated debt, are the first to lose everything, compared to leveraged loans and senior secured bonds. What is unique in the current market is that a large majority of recent leveraged financing for acquisitions was done with loans, rather than unsecured bonds. As a result, the debt food-chain has contracted, such that the normal buffer of junk bond subordinated debt that is usually in place to absorb the initial losses is smaller than normal, or in some cases non-existent. Recent data from Moody's finds that 60 percent of all issuers in the US that have rated loans, along with over 30 percent with speculative-grade issuers, have a loan-only capital structure. With such a flat structure, losses go straight to the top of the debt food-chain, thereby explaining the lower recovery rates for leveraged loans. This is certainly not good for the large bank lenders of leveraged loans, but may be even worse for the junior lenders that hold subordinated second-lien and mezzanine loans (see Reuters article). A recent Fitch report finds that the recovery rates of such subordinated holdings are expected to remain in the 0 to 10 percent range. It appears we can expect more shakeout in the credit markets, which will continue to put pressure on the banks.

The Yale University Endowment is looking for opportunities in the credit markets and distressed debt, including bank loans, investment-grade debt, and lower-grade bonds (see Bloomberg article). David Swensen, the Yale endowment investment chief, believes that distressed corporate securities will produce "equity-like" returns. He also mentions in the article how corporate governance helped the Yale endowment steer clear of the Madoff investment mess, and believes that others need to take a similar direct and transparent approach to investing. Of interest is Swensen's views on Funds-of-Funds. The Yale Investment chief states that "the reason I don't like funds of funds is that they facilitate the flow of ignorant capital." Of course, the same could be said for most mutual fund investments, and Swensen states as much, stressing that most investors should stick with passive investments like index funds since attempts to outperform the market are usually unsuccessful for retail investors. Yale recently announced that its endowment had fallen 25 percent since June (see previous post), not unlike the 22 percent loss at the Harvard endowment (see previous post). Nonetheless, even with some of the luster off the past outstanding returns from both endowments, each fund is still outperforming the general market - although, with an increasing amount of capital in alternative investments, and an equally shrinking amount in equities, comparing against traditional benchmarks such as the S&P 500 is becoming less reliable.