Special Report Altman 2010

New York University Salomon Center Leonard N. Stern School of Business

Special Report On

Defaults and Returns in the High-Yield Bond and Distressed Debt Market: The Year 2010 in Review and Outlook

By Edward I. Altman And Brenda J. Kuehne

February 04, 2011

February 04, 2011

Altman High-Yield Bond Default and Return Report

ContentsExecutive Summary ....................................................................................................................................... 3 Defaults, Default Rates, and Recoveries ........................................................................................................ 4 Bankruptcies .................................................................................................................................................. 8 Industry Defaults.......................................................................................................................................... 11 Age of Defaults ............................................................................................................................................ 12 Fallen Angel Defaults .................................................................................................................................. 13 Default Losses and Recoveries .................................................................................................................... 15 Distressed Exchanges................................................................................................................................... 18 Forecast Recovery Versus Actual ................................................................................................................ 22 Related Recovery Statistics .......................................................................................................................... 22 Mortality Rates and Losses .......................................................................................................................... 26 Returns and Spreads ..................................................................................................................................... 27 A Continuing Investment Dilemma ............................................................................................................. 30 New Issues and Other Changes in the High-Yield Market .......................................................................... 32 The Leveraging of Corporate America ........................................................................................................ 32 Proportion and Size of the Distressed and Defaulted Public and Private Debt Markets .............................. 35 Forecasting Default Rates and Recoveries ................................................................................................... 38 Appendix A: Quarterly Default Rate Comparison ....................................................................................... 42 Appendix B: Defaulted Corporate Straight Debt Issues .............................................................................. 45 Appendix C: Distressed Exchanges ............................................................................................................. 46 Appendix D: Leveraged Loan Defaults ....................................................................................................... 47 Appendix E: Chapter 11 Filings by Liability Size ....................................................................................... 48 Appendix F: Defaults by Industry ................................................................................................................ 50 Appendix G: 2010 Emergences from Default .............................................................................................. 51

Acknowledgments

Dr. Altman is the Max L. Heine Professor of Finance and Director of the Credit and Debt Markets Research Program at the NYU Salomon Center, Leonard N. Stern School of Business and a member of the Advisory Board of Paulson & Co. Brenda Kuehne is a Credit and Debt Markets Research Specialist at the NYU Salomon Center. We appreciate the assistance of Lourdes Tanglao, Siddharth Bhargava and Val Muralikrishnan of the NYU Salomon Center and the several market makers who provided us with price quotations. We offer a special thanks to the various rating agencies, Daniel Sweeney and Jonathan Blau of Credit Suisse, Steven Miller of S&P LCD, Kerry Mastroianni of New Generation Research, and Daniel Kamensky and Ty Wallach of Paulson & Co. 2

February 04, 2011


From a default, new issuance, and return performance perspective, the year 2010 proved to be an excellent year for investors and issuers of high-yield bonds, with extremely low default rates, record amounts of new issuance, and above average absolute and relative returns. Additionally, only 7.6% of outstanding high-yield bonds were classified as distressed by year-end, compared to 15% one year earlier. The default rate fell to 1.13%, an astonishing 961bp lower than last year and the lowest annual rate since 2007, prior to the credit crisis. The fourth-quarter 2010 default rate was 0.44%, approximately the same as the third-quarter 2010, but at a much lower level than one year earlier (2.59%). Default losses on high-yield bonds came in at 0.66%, based on a weighted average recovery rate of 46.6% just after default, slightly higher than the historical average. The weighted average recovery on bankruptcy and payment defaults was significantly lower at 29.9%, compared to 65.6% for distressed exchange default recoveries. Returns on high-yield bonds dropped from the record high levels of last year, ending the year at 14.32% (Citi Index). The excess return versus 10-yr US Treasuries was 6.22%, higher than the historical average of 2.77%, but well below the 65.11% experienced in 2009. Yield-to-maturity spreads versus 10-yr US Treasuries decreased to 4.58% by year-end 2010, 55bp lower than year-end 2009, and slightly below the historical average of 5.21%. Defaulted bonds and bank loans fared similarly, with a combined return of 17.7% in 2010. The distress ratio of bonds yielding more than 1,000bp above the risk-free rate decreased to 7.6% as of the end of 2010, from 12.1% three months earlier and 15.3% at year-end 2009. This metric reached its high in November 2008, with 85% of US high-yield bonds considered distressed, and has decreased steadily over the ensuing two years. Estimates of the face value size of the distressed and defaulted debt markets declined to $1.06 trillion as of December 31, 2010, down 34% from $1.61 trillion one year earlier. This decrease is attributable to both the drop in the distress ratio as well as the general decline in defaults. The market value estimate also decreased to approximately $597 billion, its lowest level since the second quarter of 2007. Based on three different methodologies, the 2011default rate forecasts range from 2.59% (distressed ratio method) to 3.90% (mortality rate method), with a consensus average rate of 3.20%.

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February 04, 2011


Defaults, Default Rates, and RecoveriesHigh-yield bond default rates plummeted in 2010 to the lowest level in three years. The rate decreased from 10.77% at year-end 2009 to 1.13% for all of 2010. Defaults include straight corporate bonds whose firms went bankrupt, missed an interest payment and did not cure it within the grace or forbearance period, or completed a distressed exchange. The 2010 rate is based on a mid-year market size of $1.22 trillion, up by $69 billion from a year earlier. In all, $13.8 billion of defaults were recorded in 2010 (Figure 1). Note in Figure 1 that the historical weighted-average annual default rate is 4.25% over the 40 year period (1971-2010). This weightedaverage rate is down compared to 4.55% at the end of 2009. Our weights are based on the par value of high-yield bonds outstanding in each year. The arithmetic annual average default rate dropped to 3.28% from 3.33% one year earlier. In the fourth quarter of 2010, the default rate was 0.44%, approximately the same as one quarter earlier (0.44%), higher than both the first two quarters of 2010, but lower than any other since the first quarter of 2008 (Figure 2 and Appendix A). Thirteen issuers defaulted in the fourth quarter on 30 issues. The most sizeable defaults during the year were those of Energy Future Holdings Corp., whose distressed exchange in the third quarter resulted in the elimination of almost $3.6 billion in existing bond debt, and $1.2 billion of defaults in the fourth quarter related to the bankruptcy filing of Ambac Financial Group. Terrestar Networks, Inc., Mashantucket Pequot Tribe, Marsico Parent Holdco, LLC, Blockbuster, Inc. and Vertis, Inc. each defaulted on outstanding bonds of $500 million or more. In all, 34 issuers constituting 55 issues defaulted in 2010 (Appendix B), a fraction of the 120 issuers and 406 issues that defaulted in 2009. The average dollar amount of defaulting bonds per defaulting issuer in 2010 was $406 million, compared to $1.04 billion in 2009, and $796 million in 2008. Lehman Brothers is not included in the 2008 statistics since its bonds were not rated non-investment grade before defaulting. In our default statistics, we include those bonds from distressed exchanges actually tendered. For example, in the Energy Future Holdings exchange, $3.59 billion of bonds were exchanged of the $4.5 billion outstanding and subject to the exchange offer. In 2010, there were seven distressed exchanges, involving as many companies, comprising $4.97 billion of defaults (36.0% of the total). See Appendix C for the list of 2010 distressed exchanges and later our discussion of these restructurings. It is important to note that we have not included either the American Capital Ltd. or First Data Corp. (FDC) restructurings. The American Capital exchange was not recognized as distressed since the noteholders participating in the exchange received either cash or new secured debt in the full principal amount of their pre-transaction debt. Likewise, the FDC exchange resulted in noteholders receiving the full principal amount of their pre-transaction amount in new notes. Additionally, in both cases, the old notes were selling at prices approximating par after the exchange announcement and through the completion of the exchange itself. Since the inclusion of the FDC exchange would have resulted in an additional $6 billion in defaults, we thought it would be of interest to note that the default rate in 2010 would have been 1.62% if the exchange had been deemed distressed. We will discuss the impact on recovery rates of this exclusion in a later section.

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February 04, 2011


In 2010, S&P and Moodys issuer-denominated default rates were 3.27% and 3.32%, respectively. Moodys 1.55% dollar-denominated default rate was lower than its issuer-denominated rate, as is usually the case when credit markets are in a strong, benign state.1 Fitchs dollar-denominated default rate for 2010 was 1.3%. The issuer-based default rate for the last 12 months in the US leveraged loan market was 2.86% (Figure 3), and 1.87% based on amount of issuance, according to S&Ps LCD compilations. This is in contrast to the significantly higher rates of 8.07% and 9.61%, respectively, at the end of 2009. As with bond defaults, issuer-based default rates tend to be higher than dollardenominated rates during benign credit periods for leveraged loans, and the reverse is true during stressed periods. During the latter periods we tend to observe not only more defaults, but larger firms are less likely to survive. See Figure 4 for the association between dollar-denominated bond default rates and economic recessions in the U.S. since the early 1970s, including the recession that recently ended in mid2009. As usual, we see the default rate peaking at or near the end of the recession, although we observed the peak before it was confirmed that the recession had indeed ended in June, 2009. Twenty leveraged loan issuers defaulted in 2010 (Appendix D), compared to 64 in 2009. According to our comparison between high-yield bond defaults (Appendix B) and leveraged loan defaults (Appendix D), only three firms had both bonds and leveraged loans default in 2010. Our forecast for 2011 is for a default rate of 3.20%. If the present extremely liquid markets persist and the proportion of low-rated companies that are able to tap both the debt and equity markets for refinancing continues, our forecast will likely be on the high-side. These scenarios depend, to a large extent, on the continuation of a low interest rate environment that the FED seems determined to encourage.

1

High Yield Bonds: Default and Loss Rate Comparison Mid-Cap Versus Large-Cap Issuers, M. Verde, P. Mancuso and E. Altman November 11, 2005, Fitch.

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February 04, 2011


Figure 1. Historical Default Rates Straight Bonds Only, Not Including Defaulted Issues from Par Value Outstanding, 19712010 (Dollars in Millions)Par Value Year Outstandinga ($) Defaults ($) Default Rates (%)

2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971

1,221,569 1,152,952 1,091,000 1,075,400 993,600 1,073,000 933,100 825,000 757,000 649,000 597,200 567,400 465,500 335,400 271,000 240,000 235,000 206,907 163,000 183,600 181,000 189,258 148,187 129,557 90,243 58,088 40,939 27,492 18,109 17,115 14,935 10,356 8,946 8,157 7,735 7,471 10,894 7,824 6,928 6,602

13,809 123,824 50,763 5,473 7,559 36,209 11,657 38,451 96,858 63,609 30,295 23,532 7,464 4,200 3,336 4,551 3,418 2,287 5,545 18,862 18,354 8,110 3,944 7,486 3,156 992 344 301 577 27 224 20 119 381 30 204 123 49 193 82

1.130 10.766 4.653 0.509 0.761 3.375 1.249 4.661 12.795 9.801 5.073 4.147 1.603 1.252 1.231 1.896 1.454 1.105 3.402 10.273 10.140 4.285 2.662 5.778 3.497 1.708 0.840 1.095 3.186 0.158 1.500 0.193 1.330 4.671 0.388 2.731 1.129 0.626 2.786 1.242Standard Deviation (%)

Arithmetic Average Default Rate

1971 to 2010 1978 to 2010 1985 to 2010

3.277 3.561 4.200 4.254 4.264 4.294 1.802

3.204 3.399 3.535

Weighted Average Default Rateb

1971 to 2010 1978 to 2010 1985 to 2010

Median Annual Default Rate

1971 to 2010

a As of midyear. b Weighted by par value of amount outstanding for each year. Source: NYU Salomon Center.

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February 04, 2011


Figure 2. 198920106.0%

Quarterly and the Four-Quarter Moving Average Default Rate

16.0%14.0% 12.0%Moving

Quarterly Default Rate

5.0%4.0% 3.0% 2.0% 1.0% 0.0%

10.0% 8.0% 6.0%

4.0% 2.0%0.0%

Source: NYU Salomon Center.

Figure 3. S&P Leveraged Loan Index 12-Month Moving Average Default Rate 19982010 (Number of Issuers)9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00%

Jun-99

Jun-00

Jun-04

Jun-05

Jun-06

Jun-09

Dec-99

Dec-00

Dec-01

Dec-04

Dec-05

Dec-06

Dec-07

Jun-10

Jun-01

Jun-02

Jun-03

Jun-07

Jun-08

Source: Standard & Poors LCD.

Dec-10

Dec-98

Dec-02

Dec-03

Dec-08

Dec-09

4 - Quarter Moving Average

Quarterly

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February 04, 2011


Figure 4. Historical Default Rates and Recession Periods in the US High-Yield Bond Market, 1972201014.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

72

76

82

86

92

96

98

02

08

74

78

80

84

88

90

94

00

04

06

Periods of Recession: 11/733/75, 1/807/80, 7/8111/82, 7/903/91, 4/0112/01, 12/07 6/09. Sources: Figure 1 of this report and National Bureau of Economic Research.

BankruptciesAs can be seen in Figure 5, the amount of total liabilities for Chapter 11 bankruptcies in 2010 was $56.8 billion, based on 114 filings. The total number of filings, for bankruptcies with liabilities greater than $100 million, was the lowest since 2007, while the total amount of liabilities was at its lowest level since 2006. Interestingly, we observe that while the total number of filings in 2010 was about one-half that of 2009, the dollar amount of liabilities was only about one-tenth! Metro-GoldwynMayer, Inc. was the largest bankruptcy filing in 2010, with $3.4 billion in liabilities, followed by The Great Atlantic & Pacific Tea Company, Inc. ($3.2 billion), and Truvo USA, LLC ($2.0 billion). Appendix E lists this years Chapter 11 bankruptcies.

8

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February 04, 2011


Figure 5. Total Filings and Liabilitiesa of Public Companies Filing for Chapter 11 Protection, 19892010Pre- Petition Liabilities, in $ billions (left axis) Number of Filings (right axis)

$800 $700 $600

280 240 200 160

2009 234 filings a nd lia bilities of $604.0 billion 2010 114 filings a nd lia bilities of $56.8 billion

$ Billion

$500 $400 120 $300 $200 $100 $0 80 40 0

a

Minimum $100 million in liabilities. Sources: Appendix E from the NYU Salomon Center Bankruptcy Filings Database.

From the record-setting 50 observed last year, the number of billion-dollar bankruptcies in 2010 decreased to 14, an amount close to the average over the 30 year period (1980-2010) of 11. The majority of the larger bankruptcies were in the financial services, communications and media, and entertainment sectors (Appendix F). According to New Generation Research, the number of public companies filings was 93 (Figure 6). The average of total liabilities for our public and private large company bankruptcy filings (114) in 2010 was $498 million, down from $2.6 billion one year earlier.

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February 04, 2011


Figure 6.

Historical Bankruptcy Filings 19802010Total Filingsb (>$100 Total Filingsa Million) Total Average Liabilitiesb Liabilitiesb Total Filings ($ MN) ($ MN) ($1 Billion) (>100 Million) (>100 Million)

Year

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total

62 74 84 89 121 149 149 112 122 135 115 123 91 86 70 85 86 83 122 145 179 263 220 172 92 86 66 78 136 207 106 3708

4 6 12 14 12 14 11 12 14 22 35 51 37 37 24 32 32 36 56 109 136 169 135 102 44 35 32 38 147 234 114 1756

0 1 3 3 0 2 3 1 2 10 10 11 14 4 1 7 0 5 6 19 23 38 41 26 11 11 4 8 23 50 14 351

746.0 3960.0 7113.0 13674.0 3440.0 8605.2 9335.4 25421.0 6905.0 33538.9 41115.1 81157.9 64224.1 17701.1 8396.0 27153.0 11687.0 18865.9 32038.3 70957.1 98895.8 228604.1 336611.7 115171.8 39549.7 142625.2 22321.6 72646.4 721009.8 603992.3 56805.7 2,924,288.0

186.5 660.0 592.8 976.7 286.7 614.7 850.5 2118.4 493.2 1524.5 1174.7 1591.3 1735.8 478.4 349.8 848.5 365.2 524.1 572.1 651.0 727.2 1352.7 2493.4 1129.1 898.9 4075.0 697.6 1911.7 4904.8 2581.2 498.3 1,665.3

a Represents both Chapter 7 and 11 public company filings; 93 Chapter 11 Filings in 2010 (Source: New Generation Research). b Filings with Total Liabilities greater than $100 million (Source: NYU Salomon Center Bankruptcy Filings Database). C Filings with Total Liabilities greater than $1 billion (Source: NYU Salomon Center Bankruptcy Filings Database).

In Figure 7, we compare the date of default with the Chapter 11 filing date for firms that defaulted on bonds and also went bankrupt going back to 1981. Based on 885 observations from the NYU Salomon Center Master Default and Bankruptcy Databases, both events occurred on the same date in 425 instances (48%). In the remaining 52% of the cases, the lag between the default date and bankruptcy date varied considerably, with decreasing levels as the two dates became further separated from each other. Of course, some defaulting issuers never formally file for bankruptcy as their problems are settled out of court or the default comes as a result of a distressed exchange, and they do not file for bankruptcy in subsequent years (many do, however see our discussion at a later point).

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February 04, 2011


Figure 7. Time Differential between Default and Bankruptcy Filinga (19812010)

60%

(425)50%

% of the Total Observations

40%

30%

20%

10%

0% 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 29 31 33 35

Number of Months Lag

a Based on 885 observations. Source: NYU Salomon Center Default and Bankruptcy Filings Databases.

Industry DefaultsFigure 8 lists the number of high-yield bond defaults by industry. Of the total 34 defaulting issuers in 2010, financial services, communications and media, and real estate/construction were industries in which a total of 18 firms defaulted. Four issuers defaulted in the general manufacturing sector, two of which are paper mills. The remaining 12 defaulting issuers were spread over various industries. Appendix E presents a more detailed breakdown of all 34 defaulting issuers. Figure 9 shows high-yield corporate bond defaults across industries per dollar amount since 1990. Although only one issuer defaulted in the energy sector, it boasted the largest dollar amount of defaults in 2010, exclusively attributable to the Energy Future Holdings distressed exchange. As in the past, we observe that the communications and media sector far outdistanced all other sectors in the dollar amount of defaulting issues over the last 20 years, primarily the result of the telecom meltdown during 200002, as well as 2009s defaults due to large-scale bankruptcies.

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February 04, 2011


Figure 8.Industry

Corporate Bond Defaults by Industry (Number of Companies)91 3 4 14 2 8 1 4 5 92 3 2 3 4 8 1 3 1 1 6 1 93 94 95 1 1 2 3 8 2 1 2 1 96 97 98 99 2000 1 1 13 1 1 6 8 9 16 8 16 4 23 6 34 6 01 02 1 8 5 5 22 4 25 3 1 5 26 7 0 03 1 9 6 6 13 3 16 04 1 2 1 3 1 2 3 6 7 1 3 4 5 10 10 1 4 6 8 7 12 36 1 7 3 4 2 3 5 05 4 06 3 07 08 8 09 10 9 Total 36 15 92 107 106 293 43 191 75 14 131 196 65 6 39 34 23 19 63 120 34 1,370

1970 89 90 Auto/Motor Carrier 6 3 Conglomerates 5 1 Energy 35 Financial Services 21 7 Leisure/ 9 8 Entertainment General 26 5 Manufacturing Health Care 4 2 Miscellaneous 16 4 Industries RealEstate/ 14 7 Construction REIT 12 Retailing 10 6 Comm. & Media 17 3 Transportation 9 1 (Non Auto) Utilities 2 Total 186 47

3 2 3 7 1 1

1 4 3

1 1 6

2 5 7

1 6 5 6 2 3 1

4 6 43 3 38 4

17

12 2 1 1

1

3 2

6 2

4

5 11

15 4 2

4 1

5 3 2

6 2

3 2

6 1 2 1

6 6 1

12 11 8

7 8 5 1

12 39 7

5 21 6 0 86

3 6 2

2 3 5

2 2 1

3 4

5 10

5 20 7

3 6

1 62 34 22 19 28

1

15 29

37

98

107 156 112


Figure 9.Industry Auto/Motor Carrier Conglomerates Energy Financial Services Leisure/ Entertainment General Manufacturing Health Care Miscellaneous Industries Real Estate/ Construction Retailing Communications & Media Transportation (Non Auto) Utilities Total1,028 4,443 18 1,968 2,605 2,675 928 498

Corporate Bond Defaults by Industry (Dollars in Millions)199190

1990468

1992 93-94

1995215

1996

1997300

1998100

1999430

2000120

20013,737

2002285 100

2003

2004280

20053,573

20062,692

2007

20081,382

200916,872

2010

Total 30,544 1,065

690

275 8,895 110 1,286 541 6,861 156 715 50 1,511 26,973 6,022 1,993 29,274 10,395

60 696 1,191

103 536 159

600 78 138

75 687 435

100 700 293 66 689 245

3,812 375 1,100

217 1,968 2,891

4,200 5,062

4,085 11,857 3,803 1,079 633

3,594 2,429 1,805 850 495

41,152 76,150 59,346 57,059 11,441 57,285 16,873 33,148

3,437 21,242

3,695 1,120 4,911 417

488

118

616 75

641

123

247 125

2,092 2,214 7,615 385

2,507 1,715 8,352 252

3,138 692 9,715 1,110

2,455 115 5,594 1,088

2,108 3,843 4,494 77

225

1,396 360

1,486

2,379 520

3,747 150 1,505 2,158

26,072

1,378 113

1,373 124

1,286 190

832

461 258

1,290 383

1,977 1,783

569 174

409

1,396

1,787 4,803

373 952 525

2,937

1,489

2,832

395

164 460

2,504 286

1,241 1,549

2,052 2,980

3,081

1,586

4,092

877 7,603

749 2,551

1,059 150

332 1,496

363 765

1,412 5,310

1,015 30,954

5,983 34,827 47,953

2,787 146,248 31,928 5,273

1,452

301

562

1,125

310

2,890

1,430

4,711

2,086

2,421 12,376

272

964

1,452

617

85

275

202

75

1,150

1,417

14,631 18,021

4,883

5,649

4,536

3,465

4,200

6,994 23,440 29,976 68,934 96,673 36,764 11,657 35,954

7,559

5,473 50,169 124,130 13,809

567,511


Age of DefaultsFigure 10 shows the age distribution of defaults in 2010 and for the period 1991 2010. It appears normal that the number of defaulting issues is low in the first year after issuance. What typically follows is an increase in default rates in years two through four. Indeed, 2010 essentially mirrors the cumulative default proportions over 19912010, in terms of marginally increasing default frequencies in years one through three, slightly lower rates in years four and five versus three. As of the end of 2010, 22% of the years defaults occurred in the third year after issuance, while a total of 49% of all defaults occurred between two to four years after issuance. There 12

February 04, 2011


was also a somewhat interesting increase in defaults of seven-year-old issues (16%) in 2010.Figure 10. Distribution of Years to Default from Original Issuance Date (By Year of Default), 199120101991Years to Default

1992

1993/1994

1995

1996/1997

1998

1999

2000

2001% of Total

No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues

1 2 3 4 5 6 7 8 9 10+ Total

0 18 26 29 35 10 4 10 3 2 1372002

0 13 19 21 26 7 3 7 2 1 100

0 0 7 10 8 12 5 4 0 8 54

0 0 13 19 15 22 9 7 0 15 100

3 6 5 2 4 8 7 0 0 2 37

8 16 14 5 11 22 19 0 0 5 100

1 9 7 3 1 2 2 2 4 1 32

3 28 22 9 3 6 6 6 13 3 100

7 7 7 17 4 5 0 0 0 2 49

14 14 14 36 8 10 0 0 0 4 100

2 5 10 3 10 2 1 0 0 0 33

6 15 30 9 30 6 3 0 0 0 100

32 37 15 14 7 8 10 2 0 0 125

26 30 12 11 6 6 8 2 0 0 100

19 51 56 14 13 5 12 4 3 6 183

10 28 31 8 7 3 7 2 2 3 100

40 69 87 65 27 14 21 5 4 3 335

12 21 26 19 8 4 6 1 1 1 100

2003

2004

2005

2006/2007

2008

2009

2010% of

19912010No. of Issues % of Total

Years to Default

No. of

% of No. of

% of No. of

% of No. of

% of No. of

% of No. of

% of No. of

% of No. of

Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total

1 2 3 4 5 6 7 8 9 10+ Total

29 51 61 56 45 21 8 7 12 54 344

8 15 18 16 13 6 2 2 3 16 100

18 30 26 23 40 20 25 3 5 13 203

9 15 13 11 20 10 12 1 2 6 100

8 7 8 6 10 16 9 6 1 6 77

10 9 10 8 13 21 12 8 1 8 100

16 13 9 22 14 17 13 11 5 64 184

9 7 6 12 8 9 7 6 3 34 100

3 5 12 14 7 13 8 12 7 6 87

3 6 14 16 8 15 9 14 8 7 100

9 18 34 30 20 10 9 6 7 11 154

6 12 22 19 13 6 6 4 5 7 100

20 39 66 61 51 58 15 18 16 62 406

5 10 16 15 13 14 4 4 5 15 100

1 6 12 9 6 5 9 2 2 3 55

2 11 22 16 11 9 16 4 4 5 100

208 371 448 378 302 226 158 92 69 243 2,495

8 15 18 15 12 9 6 4 3 10 100


Fallen Angel DefaultsFour issuers were responsible for eight defaulting issues that were investment grade at some time prior to default. Interestingly, all four issuers were financial services firms. This results in a fallen-angel issuer default rate of 1.76%, somewhat lower than the historical average of 3.80% (Figure 11). The fallen-angel default rate for 19852010 is slightly below the historical average annual rate for original issue defaults in the high-yield bond market (4.84%). This differential (3.80% vs. 4.84%), however, is not statistically significant due to a relatively high standard deviation of around 270bp per year between the two rates. Figure 12 shows the fallen angel proportion of defaults from 1977 to the present. In 2010, 15% of defaulted issues were originally rated investment grade, only slightly more than half the historical average of 27%.

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Figure 11. Fallen Angels versus Original(S&P) Issue and All High Yield Default Ratesa (In Percent)Fallen Angel Average Original Issue 12-Mo. Default Speculative Grade Rate Default Rates All Speculative Grade Bond Default Rates Altman Dollar Weighted Annual Default Rates

Year

2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 Arithmetic Average Standard Deviation

1.76 8.07 3.07 0.86 1.40 2.74 0.83 5.88 6.59 8.46 7.01 4.01 3.31 2.04 1.38 0.25 0.00 1.72 4.50 7.53 5.77 3.74 4.25 4.36 2.46 6.77 3.80 2.49

3.43 11.89 4.34 1.00 1.23 3.70 2.65 5.46 8.55 10.14 7.10 5.10 2.75 2.10 2.00 3.90 2.31 1.99 5.48 10.86 8.30 4.93 3.39 2.92 6.29 4.06 4.84 2.95

3.27 10.93 4.02 0.97 1.26 2.48 2.23 5.53 8.32 10.99 7.03 4.62 2.23 1.71 1.71 3.07 1.70 1.79 5.45 11.66 8.20 5.33 3.95 2.41 4.78 3.24 4.57 3.10

1.13 10.77 4.65 0.51 0.76 3.37 1.25 4.66 12.79 9.81 5.07 4.15 1.60 1.25 1.23 1.90 1.45 1.10 3.40 10.27 10.14 4.29 2.66 5.78 3.50 1.71 4.20 3.53

a All S&P issuer based except for Altman rates. Sources: NYU Salomon Center and S&P.

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Figure 12. 2010Year

Fallen Angel Defaulted Issues by Original Rating, 1977Total No. Defaulted Issuesa Originally Rated Investment Grade (%)

2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 Total

55 405 154 35 52 184 79 203 322 258 142 87 39 20 24 29 16 24 59 163 117 66 64 31 55 26 14 7 20 1 4 1 1 2 2,759

15 32 31 11 13 49 19 33 39 14 16 13 31 0 13 10 0 0 25 27 16 18 42 39 15 4 21 43 55 0 25 0 100 100 27%

a Where we could find an original rating from either S&P or Moody's. Sources: Moody's, NYU Salomon Center, and S&P.

Default Losses and RecoveriesThe weighted-average recovery rate (based on market prices just after defaults) on high-yield bond defaults in 2010 increased to slightly above the historic average (1978-2010) of 44.8% to end the year at 46.6%. This is higher than the recovery rate of 36.1% in 2009, and is the highest rate since 2007. The default loss rate in 2010, without an adjustment for fallen angels and including the loss of 0.060% (6.0bp) from lost coupons, was approximately 66.3bp (Figure 13). If we remove fallen angel defaults (eight issues) the loss would have been 58.6bp on original issue high-yield bonds. Of note is the fact that the recovery rate on fallen angels, contrary to the norm, was lower than on original non-investment grade bonds. This was the result of the Ambac Financial Group defaults, which recovered only 20% on average. Over the 33-year period from 1978 to 2010, the arithmetic average annual loss rate on high-yield bond defaults is 2.39%, 2.88% on a weighted-average basis (Figure 14).

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Figure 13. 2010 Default Loss RateUnadjusted for Fallen Angels (%) All Except Fallen Angels (%) Price Adjusted for Fallen Angels (%)

Only Fallen Angels (%)

Background Data Average Default Rate Average Price At Defaulta Average Price At Downgradeb Average Recovery Average Loss Of Principal Average Coupon Payment Default Loss Computation Default Rate X Loss Of Principal Default Loss of Principal Default Rate X Loss of 1/2 Coupon Default Loss of Coupon Default Loss of Principal and Coupon

1.130 46.623 46.623 53.377 10.591 1.130 53.377 0.603 1.130 5.296 0.060 0.663

1.765 12.164 48.682 24.986 75.014 6.951 1.765 75.014 1.324 1.765 3.476 0.061 1.385

1.081 51.309 51.309 48.691 11.058 1.081 48.691 0.526 1.081 5.529 0.060 0.586

1.158 46.865 48.321 51.679 10.591 1.158 51.679 0.599 1.158 5.296 0.061 0.660

a If default date price is not available, end-of-month price is used. b Downgrade to noninvestment grade. Note: Average Default Rate of Only Fallen Angels is based on number of issuers. Sources: NYU Salomon Center and various dealer quotes.

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Figure 14.

Default Rates and Losses,a 19782010 (Dollars in Millions)Par Value Outstandinga ($) Par Value of Default ($) Default Rate (%) Weighted Price After Default ($) Weighted Default Loss Coupon (%) (%)b

Year

2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978

1,221,569 1,152,952 1,091,000 1,075,400 993,600 1,073,000 933,100 825,000 757,000 649,000 597,200 567,400 465,500 335,400 271,000 240,000 235,000 206,907 163,000 183,600 181,000 189,258 148,187 129,557 90,243 58,088 40,939 27,492 18,109 17,115 14,935 10,356 8,946

13,809 124,130 50,763 5,473 7,559 36,209 11,657 38,451 96,858 63,609 30,295 23,532 7,464 4,200 3,336 4,551 3,418 2,287 5,545 18,862 18,354 8,110 3,944 7,486 3,156 992 344 301 577 27 224 20 119

1.13 10.77 4.65 0.51 0.76 3.37 1.25 4.66 12.79 9.80 5.07 4.15 1.60 1.25 1.23 1.90 1.45 1.11 3.40 10.27 10.14 4.29 2.66 5.78 3.50 1.71 0.84 1.09 3.19 0.16 1.50 0.19 1.33 3.56 4.26

46.6 36.1 42.5 66.6 65.3 61.1 57.7 45.5 25.3 25.5 26.4 27.9 35.9 54.2 51.9 40.6 39.4 56.6 50.1 36.0 23.4 38.3 43.6 75.9 34.5 45.9 48.6 55.7 38.6 72.0 21.1 31.0 60.0 44.84

10.59 8.16 8.23 9.64 9.33 8.61 10.30 9.55 9.37 9.18 8.54 10.55 9.46 11.87 8.92 11.83 10.25 12.98 12.32 11.59 12.94 13.40 11.91 12.07 10.61 13.69 12.23 10.11 9.61 15.75 8.43 10.63 8.38 10.64

0.66 7.30 2.83 0.19 0.30 1.46 0.59 2.76 10.15 7.76 3.95 3.21 1.10 0.65 0.65 1.24 0.96 0.56 1.91 7.16 8.42 2.93 1.66 1.74 2.48 1.04 0.48 0.54 2.11 0.15 1.25 0.14 0.59 2.39 2.88

Arithmetic Average 19782010 Weighted Average 19782010

a Excludes defaulted issues. b Default loss rate adjusted for fallen angels is 9.3% in 2002, 1.82% in 2003, 0.59% in 2004, 1.56% in 2005, 0.039% in 2006, 0.20% in 2007, 3.42% in 2008, 7.38% in 2009 and 0.66% in 2010. Source: NYU Salomon Center.

Figure 15 lists the average recovery rate by seniority for 19782010. In 2010, six of the defaulting issues were senior secured with an average recovery rate of only 39.5%, compared to a historical average of 57.5% (55.7% median). This is higher than the third-quarter recovery of 29.6%, but, in a reversal of the normal hierarchy, is still lower than the recovery on senior unsecured bonds. This anomaly is due to the fact that a far greater percentage of the latter defaulted due to distressed exchanges which tend to result in higher recovery rates (see discussion below). Twelve of the issues were senior unsecured with an average recovery rate of 57.9%, compared to a historical average of 37.9% (45.9% median). There were five issues that were senior subordinated with an average recovery of 30.6%, compared to an identical historical average of 30.6% (32.7% median). Two were subordinated with an average recovery of 12.7%, compared to a historical average of 30.7% (28.4% median). There were no priced defaults in 2010 in the discount and zero coupon category. Thirty issues could not be priced. The historic 33-year median for all high-yield bond defaults stayed constant at 41.8%, while the

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arithmetic average rose slightly to 37.7%. These latter statistics are based on a sample of over 2,600 defaults.Figure 15. Weighted Average Recovery Rates on Defaulted Debt by Seniority per $100 Face Amount, 19782010Senior Secured Default Year No. % $ Senior Unsecured No. % $ Senior Subordinated No. % $ Subordinated No. % $ Discount and Zero Coupon No. % $ All Seniorities No. $

2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 Total/Avg Median Standard Deva

6 29 18 10 9 67 27 57 37 9 13 14 6 4 4 5 5 2 15 4 12 9 13 4 8 2 4 1

24 10 14 36 18 54 39 28 11 3 8 11 18 16 17 15 23 6 22 3 10 12 21 13 14 7 29 13

39.46 43.70 30.52 87.24 90.60 76.50 63.67 53.51 52.81 40.95 39.58 26.90 70.38 74.90 59.08 44.64 48.66 55.75 59.85 44.12 32.18 82.69 67.96 90.68 48.32 74.25 53.42 71.00 72.00

12 226 79 10 26 44 33 108 254 187 47 60 21 12 4 9 8 7 8 69 31 16 19 17 11 3 1 3 16 2

48 76 63 36 52 36 48 53 75 67 29 47 62 48 17 27 36 22 12 44 27 21 31 55 20 11 7 38 80

57.86 37.22 49.56 47.70 60.90 45.88 56.77 45.40 21.82 28.84 25.40 42.54 39.57 70.94 50.11 50.50 51.14 33.38 35.61 55.84 29.02 53.70 41.99 72.02 37.72 34.81 50.50 67.72 39.31

5 31 23 6 8 7 2 29 21 48 61 40 6 6 9 17 5 10 17 37 38 21 10 6 7 7 2

20 10 18 21 16 6 3 14 6 17 37 31 18 24 38 52 23 31 25 24 33 28 16 19 13 26 14

30.64 24.06 30.25 63.98 50.24 32.67 37.44 35.98 32.79 18.37 25.96 23.56 17.54 31.89 48.99 39.01 19.81 51.50 58.20 31.91 25.01 19.60 30.70 56.24 35.20 36.18 65.88

2 4 4 2 1 0 0 1 0 0 26 2 0 1 4 1 3 9 22 38 24 30 20 4 30 15 7 4 4

8 1 3 7 2 0 0 0 0 0 16 2 0 4 17 3 14 28 33 24 21 39 32 13 54 56 50 50 20

12.67 12.57 21.09 46.53 60.33 0.00 0.00 38.00 0.00 0.00 26.62 13.88 0.00 60.00 44.23 20.00 37.04 28.38 49.13 24.30 18.83 23.95 35.27 35.25 33.39 41.45 44.68 41.79 32.91

0 7 1 0 6 5 7 8 28 37 17 11 1 2 3 1 1 4 5 9 11

0 2 1 0 12 4 10 4 8 13 10 9 3 8 13 3 5 13 7 6 9

0.00 16.84 2.71 0.00 78.31 74.21 43.06 32.27 26.47 15.05 23.61 17.30 17.00 19.00 11.99 17.50 5.00 31.75 19.82 27.89 15.63

1 100

50 26.71

2 50 16.63 1 100 31.00 479 18 30.58 32.67 13.93 261 10 30.71 28.38 17.38 164 6

1 100 60.00 395 15 57.54 1,344 55.75 18.25 51 37.93 45.88 13.31

25 297 125 28 50 123 69 203 340 281 164 127 34 25 24 33 22 32 67 157 116 76 62 31 56 27 14 8 20 1 4 1 1

46.62 36.13 42.52 66.65 65.32 61.10 57.72 45.58 25.30 25.62 26.74 27.90 40.46 57.61 45.44 41.77 39.44 38.83 50.03 40.67 24.66 35.97 43.45 66.63 36.60 41.78 50.62 55.17 38.03 72.00 21.67 31.00 60.00 37.70 41.78 13.68

25.45 2,643 17.50 20.58

a Standard deviations are calculated based on the yearly averages. Sources: NYU Salomon Center from various dealer quotes.

Distressed ExchangesDistressed exchanges usually represent a firms desperate attempt to avoid a formal bankruptcy filing or a payment default on outstanding debt. They were particularly popular in 2008 and 2009 as the successful outcome of Chapter 11 reorganizations became very uncertain in a difficult D.I.P. and exit financing Chapter 11 environment. Since it is also possible, however, that a proposed distressed exchange could represent a firms strategy to extract concessions from creditors when the firm has little likelihood of failing, this refinancing method continued to be used throughout 2010 as well, despite relatively liquid markets. Distressed exchanges (DEs) in 2010 accounted for 20.6% of the defaulted issuers (7 out of 34), but 36.0% of the defaulted dollar amount. From 1984 through 2010, DEs

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accounted for about 10.9% of all defaulting issuers and 12.5% of all defaulted dollar amounts (Figure 16). So, relatively speaking, 2010 was an above average year for DE activity despite highly liquid markets for firms which were most likely more creditworthy than our 2010 DE cohort. Figure 16 indicates the popular re-emergence of DEs in 2008-2010 as compared to the last 26 years. Indeed, during this three-year period, approximately 54% (67 of 124) of all DEs took place. As we have compiled in a recent study, about 46% of all DEs up to 2007 resulted in a subsequent Chapter 11 or Chapter 7 bankruptcy filing and 30% of the DE firms were acquired. The data would appear to indicate a DE is oftentimes just a short-term fix (see Altman & Karlin, 20092). However, the pace at which DEs were being sought as a restructuring alternative slowed considerably, at least in absolute terms, in the second-half of 2009 and into 2010, as other avenues of refinancing became available. Still, 21% in 2010 is a relatively high proportion of total defaulting issuers. We plan to add the 2008 DE cohort to our sample of DE firms that we used to calculate the subsequent bankruptcy activity, probably in one year.

2

The Re-emergence of Distressed Exchanges in Corporate Restructurings, E. Altman and B. Karlin, NYU Salomon Center Working Paper, 2009 (see E. Altmans website) and published in The Journal of Credit Risk, Summer 2009.

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Figure 16. 19842010

High Yield Bond Distressed Exchange (D/E) Default and Recovery Statistics,Difference Between D/E & All Default Recovery Rate

Year

D/E Defaults D/E (%) Defaults Total to Total ($) Defaults ($) $

D/E Defaults (No. of Issuers)

Total Defaults (No. of Issuers)

D/E Defaults (%) to D/E Total No. Recovery of Issuers Ratea

All Default Recovery Ratea

2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984

4,971.48 13,808.63 23,212.60 124.130.49 30,329.42 50,763.26 146.83 5,473.00 0.00 7,559.00 0.00 36,209.00 537.88 11,657.00 1,034.94 38,451.00 764.80 96,858.00 1,267.60 63,609.00 50.00 30,295.00 2,118.40 23,532.00 461.10 7,464.00 0.00 4,200.00 0.00 3,336.00 0.00 4,551.00 0.00 3,418.00 0.00 2,287.00 0.00 5,545.00 76.00 18,862.00 1,044.00 18,354.00 548.90 8,110.00 390.30 3,944.00 33.60 7,486.00 114.80 3,156.00 323.30 992.00 100.10 344.00

36.0 18.7 59.7 2.7 0.0 0.0 4.6 2.7 0.8 2.0 0.2 9.0 6.2 0.0 0.0 0.0 0.0 0.0 0.0 0.4 5.7 6.8 9.9 0.4 3.6 32.6 29.1 12.5%

7 46 14 1 0 0 5 7 3 5 1 6 2 0 0 0 0 0 0 1 7 7 3 2 4 2 1 124

34 120 64 19 0 0 39 86 112 156 107 98 37 0 0 0 0 0 0 62 47 26 24 15 23 19 12 1,134

20.6 38.3 21.9 5.3 0 0 12.8 8.1 2.7 3.2 0.9 6.1 5.4 0.0 0.0 0.0 0.0 0.0 0.0 1.6 14.9 26.9 12.5 13.3 17.4 10.5 8.3 10.9%

65.5 42.68 52.41 85.17 NA NA 58.05 78.52 61.22 33.12 77.00 65.39 17.34 NA NA NA NA NA NA 31.30 43.15 44.53 28.40 40.70 47.68 55.04 44.12 52.50b

46.62 36.13 42.50 66.65 NA NA 57.72 45.58 25.30 25.62 26.74 27.90 40.46 NA NA NA NA NA NA 40.67 24.66 35.97 43.45 66.63 36.60 41.78 50.62 42.23b

18.98 6.55 9.91 18.52 NA NA 0.33 32.94 35.92 7.50 50.26 37.49 (23.12) NA NA NA NA NA NA (9.37) 18.49 8.56 (15.05) (25.93) 11.08 13.26 (6.50) 10.27

Totals/Averages $74,432.22 $594,394.39

a Weighted-average recovery rates for each year. b Arithmetic average of the weighted-average annual recovery rates; only those years with DEs counted. The arithmetic average of each individual DE (124) for the entire sample period was 48.58% and the average for the non-DE defaults (1,010 observations) was 36.65%. Source: NYU Salomon Center.

Recovery Rates on Distressed ExchangesBecause DEs are not as dramatic a reflection of a firms distressed status as a bankruptcy or nonpayment of cash interest on debt, one might expect the recovery rate on DE defaults to be higher than other, more serious distressed situations. Of course, one reason for the larger recoveries in DEs is lenders need to be offered a premium in order to be persuaded to participate in the exchange. Figure 16 shows the arithmetic average recovery rate on all DE defaults was 52.5% for 19842010, compared to 42.2% for all defaults, and 36.6% for all non-DE defaults. In 2009, DEs recovered 42.7%, while non-DE defaults recovered only 36.1%. As the 2010 recovery rate on DEs equaled 65.6% versus 46.6% on all defaults, the spread has widened significantly from one year earlier, though 2010s calculations are based on a relatively small number of observations (7). As indicated earlier in this report, if the FDC exchange completed in December had been included in our default statistics as distressed, there would have been a significant impact on recovery rates in 2010 due to the amount of debt exchanged (approximately $6 billion) in such a low-default year. With the inclusion of this

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exchange, the 2010 recovery rate on DEs would have equaled 82.6% versus 66.3% on all defaults. In Figure 17, we calculate a difference in means test between the arithmetic average recovery rate (48.6%)3 on the 124 DE issuers (274 issues) during 19842010 and the average recovery rate on all non-DE defaults (36.6%) of the same period. We found that given the above, the DE recovery rate is significantly higher (t = 7.80) at the 1% confidence level. It is not surprising that bondholders will choose, in many instances, to accept a recovery with certainty from a DE, rather than take the chance of holding out for an uncertain and likely lower recovery in bankruptcy (see below). Our results do not include data for situations where a DE offer is rejected.Figure 17. Difference in Means Test between Recovery Rates: All Nondistressed Exchange Defaults versus Distressed Exchanges (D/E), 19842010All Defaults Excluding D/E (Issues) Distressed Exchange (Issues)

Sample Size Mean Recovery Rate Standard Deviation Variance t-testaXDE XNDE t=

2259 36.65 25.91 671.49 7.79584

274 48.58 23.65 559.30

a

Var XDE Var XNDE + NDE NNDE

Sources: NYU Salomon Center, and authors compilation.

In Figure 18, we calculate a difference in means test between the weighted average recovery rate on the announcement date of a DE versus the completion date for 2008 through 2010. Of the 42 defaulted issues in 2008 due to a DE, in which prices were available for both the announcement and completion dates, the weighted average recovery was approximately 13 percentage points higher on the completion date, while in 2009 it was less so, with only a 4.9% difference in pricing between the two dates (based on 106 observations). The reverse was true in 2010, with the weighted average recovery on five issues being 4.6% higher on announcement than completion date.4 Overall, the completion date price was higher than the announcement date in 81 of the 153 issues, just over 50% (52.9%) of the cases. Of course, market conditions in general can change between the two dates.

3

Please note that the weighted average recovery rate (48.6%) on our total sample of 124 Des is slightly lower than simply averaging the annual DE recovery rates over the 1984-2010 period (52.5%) in Figure 16. 4 The 2008 difference was significant at the .01 level; the 2009 difference at the .05 level; and the 2010 difference was not significant.

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Figure 18. Distressed Exchange Weighted Average Recovery Rates: Announcement Date versus Completion Date, 20082010# of Year Observations Announcement Date Completion Date Difference t-test

2008 2009 2010a

42 106 5

42.68 36.51 70.17

55.64 41.41 65.60

12.97 4.91 -4.57

2.69469a 1.44079b -0.33853c

Significant at the .01 level. b Significant at the .05 level. c Not significant. Source: NYU Salomon Center.

Forecast Recovery Versus ActualThe 2010 weighted-average recovery rate of 46.6% was slightly below our linear or non-linear regression default/recovery rate forecasting models predictions (Figure 19).5 We would have expected the average recovery rate to be closer to the 50%-53% range, based upon the model that we developed.Figure 19. Recovery Rate/Default Rate Association, Dollar Weighted Average Recovery Rates to Dollar Weighted Average Default Rates, 19822010Recovery Rate/Default Rate AssociationDollar Weighted Average Recovery Rates to Dollar Weighted Average Default Rates (1982-2010)70%2007 2006 1987y= y = -2.3137x + 0.5029 R2 = 0.5361 30.255x2 - 6.0594x + 0.5671 R2 = 0.6151 y = -0.1069Ln(x) + 0.0297 R2 = 0.6287 y = 0.1457x-0.2801 R2 = 0.6531

60%2004 1993 1983 1997 1996

2005

50%

1992 1984

Recovery Rate

2010

1985 1988

2003 2008 1982 1986 1989

40%

1995 1994 1998

1991

2009

30%1999 2000 2001 1990 2002

20%

10% 0% 2% 4% 6% 8% 10% 12% 14%

Default Rate

Regression equations are based on data from 19822003, with later years data points inserted to show the models effectiveness. Sources: The Link Between Default and Recovery Rates: Theory, Empirical Results and Implications, Altman, Brady, Resti, and Sironi, Journal of Business, November 2005, and NYU Salomon Center.

Related Recovery StatisticsThe recovery rate (based on price just after default) on corporate high-yield bond defaults has a fairly high variance in terms of the wide spectrum of possible outcomes, with a standard deviation of about 25%. Figure 20 shows the frequency distribution of individual issue recovery rates on over 2,500 corporate bond defaults of all seniorities since 1971. Note that the modal value is only in the 1020% range, even though our historical average recovery rate range is 3540%.

5

The Link Between Default and Recovery Rates: Theory, Empirical Results and Implications, Altman, Brady, Resti and Sironi, Journal of Business, November 2005.

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Figure 20. Corporate Bond Default Recovery Rate Frequency (Based on Number of Issues 19712010)

600

500

400

Frequency

300

200

100

0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 >100

Recovery Rate Range (%)

Number of Observations = 2,572. Source: NYU Salomon Center Default Database.

Figure 21 shows the average price at default based on the number of years after issuance. Although we observe some aging effect with the recovery rate increasing as the years to default increases, there is not a great deal of difference between the first and fifth years (3238%) or between the sixth through ninth years (4042%). The latter period is more likely to comprise fallen angel defaults than the former.Figure 21. Average Price at Default by Number of Years after Issuance (19712010)Years to Default No. of Observations Average Price ($)

1 2 3 4 5 6 7 8 9 10 AllSource: NYU Salomon Center.

179 384 478 388 306 264 168 97 64 201 2,529

33.44 34.39 32.30 37.62 37.81 42.19 42.12 42.51 39.96 34.91 36.66

Figure 22 shows the recovery rate by original rating for the entire corporate bond default database over the last 40 years. As expected, the higher the original rating, the greater the average recovery rate, but only in the investment-grade original rating range that is, among fallen angels. Once below BBB, the weighted-average recovery rate varies narrowly, 3439%. However, we observe the median recovery rates follow a continuous drop, as the original rating falls, except between the B and CCC original ratings (both 29%).

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Figure 22. 1971-2010Rating

Average Price after Default by Original Bond Rating,Average Price ($) Weighted Price ($) Median Price ($) Std. Dev. ($) Maximum Minimum Price ($) Price ($)

No. of Observatio ns

AAA AA A BBB BB B CCC Total

14 36 248 471 276 1314 313 2672

82.55 60.39 48.25 40.16 38.60 34.41 37.15 38.13

92.87 69.68 45.88 33.32 34.92 33.46 35.56 36.23

95.00 55.25 44.44 39.00 36.00 29.00 29.00 33.00

21.92 28.77 27.48 23.89 23.59 24.86 28.96 26.02

32.00 17.80 1.00 1.00 1.00 0.02 0.13 0.02

106.13 103.00 100.00 103.00 107.75 112.00 106.75 112.00

Source: NYU Salomon Center Default Database.

Earlier we showed that seniority makes a large difference in expected recoveries. It is true that the likelihood is greater that an investment-grade bond at issuance will have senior priority (secured or unsecured) than one would expect from noninvestmentgrade original issue bonds. Figure 23 shows the recovery rate by seniority, contingent upon if the original issue was rated investment grade.Figure 23. Recovery Rates by Seniority and Original Rating, Corporate Bond Defaults (By Issue, 19712010)Seniority Original Rating No. of Issues Mean Price ($) Weighted Median Price Price ($) ($) STD Minimum Price ($) Maximum Price ($)

Senior Secured

Investment Grade Non-Investment Grade All Investment Grade Non-Investment Grade All

145 273 466 486 657 1255 16 427 481 22 205 240 1 103 130

53.21 43.86 46.50 43.52 36.41 39.39 37.10 32.23 32.13 21.54 32.49 31.28 13.63 27.48 26.84

57.23 44.35 46.90 40.19 33.97 37.03 34.29 29.34 29.32 6.21 29.45 21.69 13.63 26.29 26.31

50.50 39.00 43.50 41.56 31.50 35.00 27.31 27.50 27.00 7.00 28.83 28.00

27.02 29.22 28.37 25.26 24.34 24.98 27.48 24.26 24.26 27.31 22.64 23.04

3.00 1.00 0.05 2.00 0.02 0.02 1.00 0.13 0.13 1.00 1.00 1.00 13.63

106.13 106.75 106.75 100.50 100.00 100.50 83.75 107.75 107.75 103.00 112.00 112.00 13.63 102.50 102.50

Senior Unsecured

Senior Investment Subordinated Grade Non-Investment Grade All Subordinated Investment Grade Non-Investment Grade All Discount Investment Grade Non-Investment Grade All

17.31 18.00

25.16 23.51

0.42 0.42


From Figure 23, we see considerably higher recoveries between investment-grade and noninvestment-grade bonds for senior secured (53.2% versus 43.9%) and senior unsecured (43.5% versus 36.4%), less of a difference for the senior subordinated class (37.1% versus 32.2%), and the reverse for the subordinated class. Likewise, as seniority is reduced, we see a reduction in recoveries for the investment-grade issues, but not much difference for the noninvestment-grade securities. Finally, in Figure 24, we break down recoveries by seniority for different major industrial sectors. The sectors are the same as itemized earlier when we observed the incidence of defaults per industrial sectors (Figures 8 and 9). The overall weightedaverage recovery rates are highest for energy (52.9%), utilities (51.8%), and financial services (47.3%), and lowest for general manufacturing (30.2%), communications (28.1%), and auto/motor carrier (25.7%). The rest vary between 3246%.

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February 04, 2011


Figure 24.

Recovery Rates by Industry and Seniority (19712010)No. of Issues 16 74 20 4 24 114 3 1 2 3 6 37 88 28 26 1 54 180 17 159 20 29 49 225 37 44 41 22 2 63 146 79 201 142 65 12 207 499 2 12 33 10 2 43 59 31 60 34 8 5 42 138 6 58 30 11 3 41 108 Mean Price ($) 30.78 30.09 27.26 34.28 28.43 29.84 44.92 71.00 11.50 31.33 38.13 63.25 45.17 38.15 25.38 45.26 32.00 44.94 32.71 49.50 31.97 21.69 25.89 43.09 50.69 37.66 30.39 45.07 18.88 35.52 39.78 40.89 33.67 31.69 34.95 17.90 32.71 34.04 91.25 46.90 24.50 23.77 21.05 24.33 31.08 44.24 51.45 35.26 38.67 4.37 35.91 43.40 50.58 46.96 26.73 35.98 13.61 29.21 39.50 Weighted Price ($) 24.96 26.37 21.77 25.71 22.21 25.75 47.94 71.00 15.19 22.52 40.93 65.24 47.86 46.60 25.39 45.26 42.22 52.91 26.45 55.92 28.85 8.81 12.70 47.29 55.86 30.66 26.73 48.53 20.74 32.03 37.34 41.44 27.20 29.04 27.99 27.17 28.76 30.17 97.38 49.61 21.06 17.57 27.07 20.50 31.72 46.49 54.88 36.45 17.59 4.27 35.20 45.87 52.55 37.70 21.24 25.21 20.97 21.86 32.08 Median Price ($) 24.00 23.91 23.50 27.00 25.00 25.00 53.38 11.50 18.00 40.69 64.00 43.50 34.88 21.13 27.50 40.69 14.00 51.75 28.00 5.00 20.00 38.50 52.50 27.86 23.00 36.00 18.88 28.83 34.75 39.44 29.88 27.75 32.00 8.72 29.00 29.75 91.25 55.50 15.50 23.50 21.05 18.00 29.00 43.50 54.36 27.90 34.07 4.03 29.81 40.00 58.75 44.25 16.25 21.88 13.63 18.00 32.31 STD 24.46 22.86 19.93 21.25 19.85 22.31 14.65 9.19 34.96 25.10 32.44 21.83 23.97 12.19 20.11 26.13 24.60 28.11 24.07 26.60 25.85 29.08 25.98 26.79 25.40 29.53 9.73 27.59 27.43 25.51 22.21 23.84 21.15 23.25 23.03 23.27 10.25 15.38 23.11 13.41 18.32 21.11 24.27 27.26 26.01 25.89 23.53 2.79 25.21 27.31 34.50 23.05 26.28 33.65 12.40 28.30 27.15 Minimum Price ($) 2.71 4.00 3.00 18.00 3.00 2.71 28.00 71.00 5.00 5.00 5.00 2.00 6.75 1.00 9.50 45.26 1.00 1.00 5.00 0.02 1.00 1.00 1.00 0.02 0.05 3.75 3.00 7.00 12.00 3.00 0.05 1.75 0.25 0.75 2.00 0.75 0.75 0.25 84.00 8.75 0.13 4.75 8.09 0.13 0.13 5.00 8.00 1.00 4.00 0.75 1.00 0.75 3.00 4.00 2.00 2.00 1.21 2.00 1.21 Maximum Price ($) 92.00 93.60 71.00 65.13 71.00 93.60 53.38 71.00 18.00 71.00 71.00 104.50 86.38 107.75 55.00 45.26 107.75 107.75 94.00 100.00 92.00 103.00 103.00 103.00 106.00 100.00 99.00 112.00 25.76 112.00 112.00 106.75 99.50 106.00 90.88 66.50 106.00 106.75 98.50 56.00 86.00 39.00 34.00 86.00 98.50 93.50 99.00 96.00 88.00 8.00 96.00 99.00 82.50 100.50 95.50 98.25 26.00 98.25 100.50

Industry Seniority Auto/Motor Carrier Senior Secured Senior Unsecured Senior Sub Subordinated Senior Sub +Sub All Conglomerates Senior Unsecured Senior Sub Subordinated Senior Sub +Sub All Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All

Energy

Financial Services Senior Secured Senior Unsecured Senior Subordinated Subordinated Senior Sub +Sub All Leisure & Entertainment Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All

General Mfg

Healthcare

Misc. Industries

Real Estate & Construction

25

February 04, 2011


Figure 24.Industry Retailing

Recovery Rates by Industry and Seniority (19712010) (Continued)Seniority Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All Senior Secured Senior Unsecured Senior Sub Subordinated Senior Sub +Sub All No. of Issues 29 155 74 36 3 110 297 64 301 50 17 101 67 533 121 73 6 8 14 208 27 27 2 2 1 4 59 Mean Price ($) 46.45 45.09 31.89 27.27 35.85 30.38 39.68 36.93 30.49 37.59 32.00 28.82 36.17 31.66 50.23 29.39 41.71 29.89 34.96 41.89 56.57 78.34 43.88 44.00 68.00 43.94 65.87 Weighted Price ($) 41.06 45.08 28.83 25.44 35.51 28.11 36.56 36.44 26.17 33.10 37.86 26.59 33.49 28.06 60.59 27.65 25.24 20.50 22.14 44.74 39.27 65.03 52.92 44.00 68.00 51.51 51.83 Median Price ($) 43.50 43.50 25.25 20.00 20.00 23.00 40.00 27.67 24.00 32.50 20.00 20.00 29.50 24.00 44.00 24.00 36.75 26.06 33.63 34.25 56.25 84.00 43.88 44.00 44.00 77.00 STD 25.26 20.37 22.68 18.96 33.26 21.55 22.51 31.18 22.69 25.72 25.84 23.55 25.67 24.49 26.49 19.05 25.99 21.63 23.42 25.82 24.69 18.34 36.95 0.00 21.33 24.36 Minimum Price ($) 2.50 0.23 0.50 3.38 13.48 0.50 0.23 1.00 1.00 0.13 6.50 0.42 0.13 0.13 2.00 6.00 13.00 10.00 10.00 2.00 2.00 28.88 17.75 44.00 68.00 17.75 2.00 Maximum Price ($) 90.00 98.50 94.00 70.00 74.06 94.00 98.50 99.00 95.75 97.00 89.00 102.50 97.00 102.50 106.13 99.00 83.75 65.50 83.75 106.13 99.88 98.63 70.00 44.00 68.00 70.00 99.88

Communications & Media

Transport (Nonauto)

Utilities

Senior Secured Senior Unsecured Senior Sub Subordinated Discount Senior Sub +Sub All


Mortality Rates and LossesA method we developed in 1989, and updated annually since, to assess the probability of default of newly issued corporate bonds and also to forecast default rates (see below) is the mortality rate approach. This default measurement includes the impact of bond aging by adjusting the base population over time for such disappearances as defaults, calls, and other noncredit-related events. Results are calculated based on the rating at birth and the volume of issuance. Similar statistics for cumulative default rates can be found from rating agency compilations, only the base is usually the number of issuers. These agency-calculated cumulative default rates are based on the number of issuers in a certain rating category at the beginning of the same year, regardless of the rating received when they were issued. Hence, they are not affected by aging, and the statistics are more appropriate for seasoned portfolios.

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February 04, 2011


Figure 25.

Mortality Rates by Original Rating All Rated Corporate Bondsa (19712010)Years After Issuance 1 2 3 4 5 6 7 8 9 10

AAA AA A BBB BB B CCC

Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative

0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.38% 0.38% 1.03% 1.03% 2.97% 2.97% 8.35% 8.35%

0.00% 0.00% 0.00% 0.00% 0.07% 0.08% 2.50% 2.87% 2.10% 3.11% 7.88% 10.62% 12.45% 19.76%

0.00% 0.00% 0.26% 0.26% 0.17% 0.25% 1.38% 4.21% 3.97% 6.95% 7.97% 17.74% 18.25% 34.40%

0.00% 0.00% 0.11% 0.37% 0.18% 0.43% 1.06% 5.23% 2.02% 8.83% 7.95% 24.28% 16.42% 45.17%

0.02% 0.02% 0.02% 0.39% 0.14% 0.57% 0.59% 5.79% 2.38% 11.00% 5.85% 28.71% 4.85% 47.83%

0.02% 0.04% 0.01% 0.40% 0.11% 0.68% 0.28% 6.05% 1.48% 12.32% 4.58% 31.97% 11.85% 54.02%

0.01% 0.05% 0.01% 0.41% 0.04% 0.72% 0.32% 6.35% 1.53% 13.66% 3.68% 34.48% 5.40% 56.50%

0.00% 0.05% 0.01% 0.42% 0.31% 1.03% 0.18% 6.52% 1.12% 14.63% 2.16% 35.89% 4.98% 58.67%

0.00% 0.05% 0.03% 0.45% 0.11% 1.13% 0.17% 6.68% 1.52% 15.93% 1.85% 37.08% 0.71% 58.96%

0.00% 0.05% 0.01% 0.46% 0.07% 1.20% 0.36% 7.01% 3.21% 18.63% 0.83% 37.60% 4.45% 60.78%

a Rated by S&P at issuance based on 2,572 issues. Sources: S&P and NYU Salomon Center.

Figure 26.AAA AA A BBB BB B CCC

Mortality Losses by Original Rating All Rated Corporate Bondsa (19712010)Years After Issuance 1 2 3 4 5 6 7 8 9 10

Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative

0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.28% 0.28% 0.59% 0.59% 1.99% 1.99% 5.50% 5.50%

0.00% 0.00% 0.00% 0.00% 0.03% 0.03% 1.62% 1.90% 1.22% 1.80% 5.51% 7.39% 8.93% 13.94%

0.00% 0.00% 0.04% 0.04% 0.08% 0.11% 1.18% 3.05% 2.35% 4.11% 5.40% 12.39% 12.87% 25.01%

0.00% 0.00% 0.04% 0.08% 0.14% 0.25% 0.43% 3.47% 1.18% 5.24% 5.30% 17.03% 12.00% 34.01%

0.01% 0.01% 0.01% 0.09% 0.08% 0.33% 0.38% 3.84% 1.42% 6.59% 3.91% 20.28% 3.42% 36.27%

0.01% 0.02% 0.01% 0.10% 0.05% 0.38% 0.18% 4.01% 0.77% 7.31% 2.52% 22.29% 8.92% 41.95%

0.01% 0.03% 0.00% 0.10% 0.03% 0.41% 0.13% 4.13% 0.84% 8.09% 2.39% 24.14% 4.07% 44.32%

0.00% 0.03% 0.01% 0.11% 0.05% 0.46% 0.10% 4.23% 0.49% 8.54% 1.21% 25.06% 3.85% 46.46%

0.00% 0.03% 0.01% 0.12% 0.07% 0.53% 0.11% 4.34% 0.80% 9.27% 0.95% 25.77% 0.45% 46.70%

0.00% 0.03% 0.01% 0.13% 0.03% 0.56% 0.21% 4.54% 1.14% 10.30% 0.58% 26.21% 2.85% 48.22%

a Rated by S&P at issuance based on 2,120 issues. Sources: S&P and NYU Salomon Center Default Database.

Updated mortality statistics are reported in Figures 25 and 26. Since the 2010 default rate dropped so dramatically from 2009, and were relatively low compared to historical norms, the updated mortality rate statistics tend to be lower than one year earlier. For example, the one- and five-year B-rated category had cumulative mortality rates of 2.97% and 28.71% in 2010 compared to 3.08% and 29.38% in 2009. We utilize our mortality rate statistics in one of our default forecasts at the end of this report. Mortality losses in Figure 26 indicate a parallel story to the mortality rate statistics. Most losses are lower than at the end of 2009, due to the low amount of defaults.

Returns and SpreadsFigure 27 shows the return on high-yield bonds for 2010 was 14.32. The excess return versus 10-yr US Treasury bonds was 6.22%, far lower than that of 2009, when the excess return (loss) was 65.11%, but still above average. The average excess return spread increased to 2.77% (2.34% compound average) from one year earlier when it was 2.66% (2.22% compounded).

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February 04, 2011


The spread between the yield-to-maturity on high-yield bonds versus 10-yr Treasuries decreased by 106bp from 564bp at the end of the third quarter to a yearend total of 458bp, the lowest since year-end 2006. Figure 28 shows the spread trend from its all-time low of 260bp in June 2007, to the peak spread of 2,046bp in December 2008, then its steady decline through the end of 2010. The spread had been very stable for the entire year, 2010.

Defaulted Debt ReturnsIn a subsequent report (to be published shortly), we will analyze the recent risk and return performance of the distressed debt markets, especially for those investors who concentrate on defaulted bonds and bank loans. As we will discuss later in this report, as well as in our subsequent one, distressed markets can include those debt securities that are trading at large discounts from par value but are still current on their interest payments as well as those that have already defaulted but still trade. In 2010, the Defaulted bond and loan securities and private debt facilities realized sound annual returns. The Altman-Kuehne Index of Defaulted Bonds ended 2010 with a return of 25.76%, and the Index of Defaulted Loans also performed solidly increasing by 9.98%6. The Combined Index of Defaulted Bonds and Bank Loans was up by 17.70%, the fourth highest return in its 15 year history. Other defaulted/bankrupt bond indexes had an equally successful year, including Moodys bankrupt bond index return of approximately 23% and Credit Suisses defaulted bond index, up 19.5%. As for distressed debt, hedge-fund indexes, 2010 was also a solid year, almost as much so as the long-only, 100% invested defaulted debt indexes reported above. These indexes reflect actual performance averages of samples of hedge funds. Results were Hennesseys (14.76%), HFRs (11.26%), Dow Jones/Credit Suisse (10.26%) and Greenwich Van Hedge (16.00%).

6

The NYU Salomon Center maintains three defaulted debt indexes and reports these performance statistics on a monthly total return basis. For more information, call (212) 998-0701.

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February 04, 2011


Figure 27. Annual Returns, Yields, and Spreads on 10-Yr Treasury and High-Yield Bonds,a 19782010Return (%) Year High Yield Treasury Excess Returns Yield to Maturity (%) High Yield Treasury Spread

2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 Arithmetic Annual Average 19782010 Standard Deviation Compound Annual Average 19782010

14.32 55.19 (25.91) 1.83 11.85 2.08 10.79 30.62 (1.53) 5.44 (5.68) 1.73 4.04 14.27 11.24 22.40 (2.55) 18.33 18.29 43.23 (8.46) 1.98 15.25 4.57 16.50 26.08 8.50 21.80 32.45 7.56 (1.00) 3.69 7.57 11.11 15.34

8.10 (9.92) 20.30 9.77 1.37 2.04 4.87 1.25 14.66 4.01 14.45 (8.41) 12.77 11.16 0.04 23.58 (8.29) 12.08 6.50 17.18 6.88 16.72 6.34 (2.67) 24.08 31.54 14.82 2.23 42.08 0.48 (2.96) (0.86) (1.11) 8.34 11.55

6.22 65.11 (46.21) (7.95) 10.47 0.04 5.92 29.37 (16.19) 1.43 (20.13) 10.14 (8.73) 3.11 11.20 (1.18) 5.74 6.25 11.79 26.05 (15.34) (14.74) 8.91 7.24 (7.58) (5.46) (6.32) 19.57 (9.63) 7.08 1.96 4.55 8.68 2.77 18.06

7.87 8.97 19.53 9.69 7.82 8.44 7.35 8.00 12.38 12.31 14.56 11.41 10.04 9.20 9.58 9.76 11.50 9.08 10.44 12.56 18.57 15.17 13.70 13.89 12.67 13.50 14.97 15.74 17.84 15.97 13.46 12.07 10.92 12.09 3.24

3.29 3.84 2.22 4.03 4.70 4.39 4.21 4.26 3.82 5.04 5.12 6.44 4.65 5.75 6.42 5.58 7.83 5.80 6.69 6.70 8.07 7.93 9.15 8.83 7.21 8.99 11.87 10.70 13.86 12.08 10.23 9.13 8.11 6.88 2.81

4.58 5.13 17.31 5.66 3.11 4.05 3.14 3.74 8.56 7.27 9.44 4.97 5.39 3.45 3.16 4.18 3.67 3.28 3.75 5.86 10.50 7.24 4.55 5.06 5.46 4.51 3.10 5.04 3.98 3.89 3.23 2.94 2.81 5.21 2.88

10.10

7.76

2.34

a Year-end yields. Sources: Citi Yieldbook and authors compilations.

Figure 28. Spread Between High-Yield Bonds YTM and 10-Yr Treasury Notes, 1 Jun 0731 Dec 102,200 2,000 1,800 1,600 1,400 1,200 1,000 800

12/16/08 (2,046bp)

12/31/10 (458bp)600 400 200

4/26/10 (442bp) 6/12/07 (260bp)

Source: Citigroup Yieldbook Index Data

6/1/2007 7/2/2007 7/31/2007 8/29/2007 9/27/2007 10/26/2007 11/26/2007 12/26/2007 1/25/2008 2/25/2008 3/25/2008 4/23/2008 5/22/2008 6/20/2008 7/21/2008 8/19/2008 9/17/2008 10/16/2008 11/14/2008 12/15/2008 1/15/2009 2/13/2009 3/16/2009 4/14/2009 5/13/2009 6/11/2009 7/10/2009 8/10/2009 9/8/2009 10/7/2009 11/5/2009 12/4/2009 1/6/2010 2/4/2010 3/5/2010 4/5/2010 5/4/2010 6/2/2010 7/1/2010 7/30/2010 8/30/2010 9/28/2010 10/27/2010 11/25/2010 12/24/2010

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February 04, 2011


A Continuing Investment DilemmaNormally, in a credit environment of extremely low default risk, both in terms of recent and near-term future estimates, yield spreads should be below average and the outlook for risky debt markets fairly bullish. The yield spread at the end of 2010 (Figure 27) is exactly that, having dropped from 564bp, and above average, at the end of the third quarter to 458bp at year-end 2010 (vs. 521bp average). However, we feel that there is still uncertainty about the future due to concerns about European sovereign and banking default risk, inflation and interest rate increases, and the refinancing needs of the private and government sectors in the U.S. These uncertainties would seem to justify at least a normal required return, risk premium situation. Indeed, if anything, yield spreads appear to us slightly below average for the uncertainties going forward. The stock market looks undervalued, with P/E ratios relatively low, excellent growth in many corporate profits (and the economy as well), albeit mainly from cost-cutting, and interest rates still at extremely low levels. With all of the above in mind, one could be fairly bullish about the stock markets prospects, yet bearish, or at least not very optimistic about bond markets, especially high-yield. Considering investment choices between various capital markets, it is instructive to observe historical correlations with particular scrutiny of the most recent past. Figure 29 shows the correlation between the S&P 500 stock index monthly returns vs. both high-yield and defaulted debt indexes. The latter are based on our AltmanKuehne Defaulted Bond and the Combined Defaulted Bond and Bank Loan Indexes. The periods covered are the last three stressed credit cycles: 1990/1991, 2001/2002, and the most recent 2008-2010 period. We also observe the correlations for the recovery period since April 2009, and other past recoveries (not shown here), as well as the entire sample period 1987-2010. The results are quite startling. Typically during stressed credit cycles (and also the subsequent recovery), correlations between the stock market and risky debt markets are quite low - - 12% in 1990/1991, 23% in 2001/2002, and, not shown, -16% and 43% in their subsequent recoveries. Over the entire sample period since we have been tracking defaulted debt as an asset class (1987present), the correlation between the S&P 500 and defaulted debt is only 40%, and a moderate 57% for the high-yield market and stock market. However, in the most recent economic and financial collapse of 2008early 2009, correlations spiked enormously to 73% and they have continued in the recovery to 66%. In the most recent cycle (April-December 2010), the correlation between defaulted bonds and bank loans and the S&P 500 Stock Index was 77%. On any given day, it is almost certain that if there is bad news about financial or default related uncertainties, both risky bond and stock markets decline, with a flight to quality, and the opposite is true if the news is positive. Our dilemma, much as it has been for all of 2010, is that if we are to be bearish about risky debt in the near future, how can we be bullish about the stock market? If the main uncertainties diminish, for example in Europe, and/or the real economies in the U.S., Europe and even China improve, can we be very confident about common stocks. The latter uncertainty seems to have diminished considerably of late. A more positive spin on the correlation pattern is that the optimistic stock market outlook

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February 04, 2011


will dominate bond market uncertainties and both will prosper in the near-term future.Figure 29. Total Monthly Return Correlations on Various Asset Class Indexes during Stressed and Recovery Credit CyclesCiti HY Index S&P 500 Stock Index Stressed Cycle Ia 01/1990 12/1991 (24 obs.) Defaulted Bond Index S&P 500 Stock Index 68% 48% 12%

Stressed Cycle IIb 01/2001 12/2002 (24 obs.)

Defaulted Bond Index S&P 500 Stock Index

76% 54%

23%

Defaulted Bond Index Stressed Cycle III 01/2008 03/2009 (15 obs.) S&P 500 Stock Index

80% 73%

73%

Defaulted Bond Index Recovery Cycle 04/2009 12/2010 (21 obs.) S&P 500 Stock Index

70% 67%

66%

Defaulted Bond Index Full Sample Period 01/1987 12/2010 (288 obs.) S&P 500 Stock Index

65% 57%

40%

Defaulted Bond Index Most Recent Cycle 04/2010 12/2010 (9 obs.) S&P 500 Stock Index

85% 81%

77%

a Correlation between Defaulted Bond Index and S&P 500 during recovery cycle was -16%. b Correlation between Defaulted Bond and Bank Loan Index and S&P 500 during recovery cycle was 43%, and the Defaulted Bond Index and the S&P was 49%. Source: E. Altman, NYU Salomon Center.

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February 04, 2011


New Issues and Other Changes in the High-Yield MarketNew high-yield bond issuance in 2010 increased dramatically to a record $218.87 billion compared to the previous record set only last year of $171.9 billion. New issuance of leveraged loans increased three-fold in 2010, with S&P estimating that about $233 billion of new, US leveraged loans were issued during the year, up from a record-low $77 billion in 2009. The size of the high-yield bond market, adjusting for fallen angels, rising stars, defaults, and other changes, was approximately $1.28 trillion at the end of 2010, up from $1.18 trillion at the end of 2009 (see Figure 30). The increase of almost $100 billion over last year is largely attributable to the dollar amount of newly issued debt greatly exceeding defaults and other exits from the market. In three of the four quarters of 2010, upgrades exceeded downgrades, indicating a perceived improvement in credit fundamentals over the course of the year.Figure 30. Market Changes in 2010 and Size of the High-Yield Bond Market (Dollars in Billions)Size of Market (as of December 2009) $1,183.0

New Issues Fallen Angels Rising Stars Defaults Calls Repurchases/Tenders Maturities Exchanges Size of Market (as of December, 2009)a

$218.8 $24.8a $(31.6)b $(13.8) $(41.9) $(62.3) $(21.0) $21.9 $1,277.8b

First downgrade to noninvestment grade from either Moodys or S&P. grade with both Moodys and S&P. Sources: Citigroup, Credit Suisse, and NYU Salomon Center.

Must be investment

The Leveraging of Corporate AmericaOver the past 24 months, we have witnessed an enormous amount of new issuance in both the investment grade and high-yield bond markets as well as the apparent awakening of the leveraged loan market of late. Indeed, as stated above, new issuance of high-yield bonds in 2010 broke the previous record set a year earlier. These developments are all the more astounding given the fact that the default rate in 2009 was the second highest ever (see Figure 1) and we just recently went through the most challenging credit cycle since the great depression. What accounts for this impressive recovery in issuer appetite for leverage and also investor optimism in absorbing this record new issuance? We can identify at least four reasons to explain the substantial leveraging of corporate America (or releveraging as some analysts point out that the U.S. economy leveraged up dramatically prior to the credit meltdown in 2007 - 2008). These four include:

7

According to Credit Suisse data.

32

February 04, 2011


1. Refinancing needs of existing high-yield bonds and leveraged loans, 2. Unprecedented low interest rates, which has persisted, 3. Attempts to sustain and enhance return-on-equity gains in recent quarters, and 4. Building of a cash horde to participate in M&A activity in the future.

RefinancingEstimates of the use of new high-yield bond issues, in both 2009 and 2010, show the enormous receptivity of investors in both high-yield bonds and leveraged loans to accept new, longer maturity bonds to replace those bonds that were set to mature in 20102012. The revised chart (Figure 31) shows that the upcoming debt maturities of corporate bonds, loans, and commercial mortgages have been pushed out, in many cases, to maturity dates beyond 2013. Indeed, in just the period from April to September 2010, the LSTA reports that the reduction in leveraged loans maturing in 20092013 was about $17 billion, $20 billion, $43 billion, $72 billion and $11 billion, respectively, with the largest increase in loan maturities moved to 2015 ($80 billion). Similar reductions in near-term maturity are observable for high-yield bonds. Critics of these developments point out that short-term adjustments in maturities merely kick the can down the road and add to later year uncertainties. Proponents point out that refinancing successes illustrate that many firms credit profiles are improving and now is the time to take advantage of the low interest rate window of opportunity. The trick is, in our own opinion, not to overdo a good thing. Of course, if firms merely replace existing higher interest debt with lower cost issues, and extend maturities at the same time, then bankruptcy risk, especially in the short-term, will be reduced and expected default rates will be reduced compared to what models based on longer-term dynamics would indicate.

Interest RatesWith the FED providing enormous liquidity and with investor appetite for risky debt and higher yielding assets substantial, interest rates have remained stubbornly low; indeed, they have even dropped considerably. Figure 27 shows that the yield on a 10year Treasury fell from 3.84% to 3.29% in the last twelve months and is now amongst the lowest levels in our entire 33 years of data. Only the 2.22% yield at the end of 2008, during the peak of the credit meltdown, was lower. Additionally, the high-yield bond yield-to-maturity level (7.87%) is about 4% below historical averages and is the lowest level since 2006. In fact, in only two year-end instances out of 33 (2004 and 2006) were yields lower. So, despite record demand for highyield bonds, interest rates are absolutely and relatively low. Average yields have dropped despite the increasing risk profile of high-yield bonds. As seen in Figure 32, the percentage of new high-yield issuance with ratings B- or lower has crept up from 17.5% in 2008 to 26.7% as of the end of 2010. The current percentage is still at historical average levels (the median year-end level of this percentage is just above the current level).

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February 04, 2011


ROE EnhancementOne of the promising aspects of the current high-yield and equity environment is the increase in earnings and interest coverage levels of U.S. companies. Despite rising leverage levels, near-term default risk seems to be lessening in tandem with actual falling default levels. Since there is little new investment taking place beyond inventory replacement and also with lackluster consumer demand, earnings increases in 2009 and 2010 are more than likely a function of cost cuts and rising leverage levels. With cost-cutting likely to now be near fully exhausted, any continued earnings enhancements are likely to come from (1) what is known as trading on the equity, i.e. earnings before interest and after taxes that are higher than the cost of new debt and (2) M&A activity (our next factor). Again, skeptics of the strategy point out the double-edged sword of leverage increased potential returns but higher default risk if earnings levels fall below the cost of debt.

M&A ActivityOur final motivation for corporate Americas appetite for higher leverage is cheap financing for M&A activity. Not only is debt financing relatively cheap today, but also it is non-dilutive for the potential acquirers equity. There are already signs of a pickup in M&A activity and in private equity funds acquisitions, especially in the middle-market arena. We expect this merger trend to accelerate as firms seek ways to sustain and enhance ROE performance.Figure 31. Upcoming Debt Maturities: 2010 2018: High-Yield Bond, Leveraged Loan and Commercial MortgagesHigh Yield700 600 500270

Leveraged Loans

Commercial Mortgages

$Billion

400265

300236 261 134

45 87

1 21 87

200 100 05 188 7

2 13299

211 67 54 83

33 54

126

162

135

146

2010

2011

2012

2013

2014

2015

2016

2017

2018 +

Sources: J.P. Morgan & MarkIt as of September 17, 2010 and S&P LCD.

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Figure 32. Percentage of New High-Yield Issues Rated B- or Below, 19932010 (Based on the Amount of Issuance)60.00%

51.25%

50.00%

40.75% 39.06%

40.00%32.97% 30.41% 29.55% 26.66% 23.35% 18.16% 19.40% 14.02% 13.73% 17.49% 21.48% 21.33% 33.00% 33.57%

30.00%

27.27%

20.00%

10.00%

0.00%1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Standard & Poors Global Fixed Income Research.

Proportion and Size of the Distressed and Defaulted Public and Private Debt MarketsThe distressed and defaulted debt proportion of the high-yield plus defaulted debt markets in the United States comprised roughly 23.0 %, as of December 31, 2010 down considerably from 31.5% one year earlier (Figure 33). The primary reason for the steady decrease since December 31, 2008 was the drop in the distress ratio of issues trading at least 1,000bp over the 10-yr US Treasury bond. This ratio fell from 12.4% of the high-yield bond market, as of year-end 2009, to 7.6% by the end of 2010 and from 12% to 6% of the high-yield + defaulted debt markets. As a result, the distressed segment comprised only 6% of the total high-yield plus defaulted debt market ($1.533 trillion) as of year-end, while the defaulted segment decreased to 17%, slightly below the prior two years.Figure 33. Distresseda and Defaulted Debt, as a Percentage of Total High Yield Plus the Defaulted Debt Market,b 19902010c90%

80%

Defaulted70%

Distressed

60% 67%

50%

40% 17%

30%

28% 31% 8% 26% 6% 7% 3% 2% 9% 13% 5% 22%

21%12% 5% 3% 4% 14% 1% 13% 9% 18% 10% 19% 17% 6%

20%

10% 14% 0%

15%

19%

18%

14%

7%

1990 1992 1993 1995 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

a Defined as yield-to-maturity spread greater than or equal to 1,000bp over comparable Treasuries. b $1.533 trillion as of December 31, 2010. c Some years not available as no survey results are available. Source: NYU Salomon Center, Merrill Lynch (Bank of America).

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The defaulted bond amount total is derived by adding the new defaults of 2010 ($13.81 billion) to the existing defaulted bonds as of year-end 2009, subtracting those bonds of firms whose reorganization plans were deemed effective and have emerged from Chapter 11 ($33.4 billion Appendix G) and, finally, by deducting the value of bonds which defaulted as part of a distressed exchange during the year ($5.0 billion). The latter, while part of our defaulted total, do not trade after the exchange, or trade as non-defaulted debt.Figure 34. Estimated Face and Market Values of Defaulted and Distressed Debt, 20082010 (Dollars in Billions)Face Value ($) 31 Dec 08 31 Dec 09 31 Dec 10 Market Value ($) 31 Dec 08 31 Dec 09 31 Dec 10 Market/ Face Ratiod

Public Debt Defaulted Distressed Total Public Private Debt Defaulted Distressed Total Private Total Public and Private

234.36 888.53 1,122.89 515.59 1,954.76 2,470.35 3,593.24

279.87 180.95 460.82 699.67 452.38 1,152.05 1,612.86

255.27 a 97.32 b 352.59 510.54 c 194.64 c 705.17 1,057.76

40.69 488.69 529.38 299.11 1,368.33 1,667.44 2,196.82

97.95 135.71 233.67 419.80 361.90 781.70 1,015.37

102.11 68.12 170.23 280.79 145.98 426.77 597.00

0.40 0.70

0.55 0.75

a Calculated using: (2009 defaulted population) + (2010 defaults) - (2010 Emergences) (2010 Distressed Restructurings). b Based on 7.62% of the size of the high-yield market ($1.278 trillion). c Based on a private/public ratio of 2.0. d The market/face value ratio was 0.35 for public defaulted debt, 0.75 for public distressed debt, 0.60 for private defaulted debt and 0.80 for private distressed debt in 2009. Source: NYU Salomon Center and estimates by Professor Edward I. Altman.

Figure 34 shows our estimate of the size of the defaulted and distressed debt markets for both public and privately issued debt. The estimated face value of distressed public bonds is $97.3 billion, down from $181.0 billion one year earlier. As previously discussed, this is attributable to the decrease in the distress ratio. We are now using a private-to-public debt ratio of 2.0 times8 (decreased from 2.5 times in prior reports) to estimate the amount of defaulted and distressed private debt (mainly bank loans, mortgages, and trade debt). Applying the 2.0 ratio to our public debt totals, we estimate that the face value of private defaulted and distressed debt is $705.2 billion. The total face value of public and private, defaulted and distressed debt as of December 31, 2010, is an estimated $1.06 trillion (Figure 34). This is a staggering decrease of about $555 billion from one year earlier, primarily due to the decrease in the distress ratio as well as the re-evaluation of the private-to-public ratio. As indicated in Figure 34, consistent with our observations of both newly defaulted and existing defaulted loan issues in our NYU Salomon Center Index of Defaulted Bond and Bank Loan performance, we have chosen to slightly decrease our marketto-face value ratios from year-end 2009. When applied, the market value estimate of

8

Based on an updated sample of over 150 bankrupt firms from 2007-2009.

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February 04, 2011

Altman High-Yi

Documents

Special Report Altman 2010