I have expressed my thoughts about low future recovery rates in firm defaults throughout 2008-09 (Jan 8, 2008, May 7, 2008 and on Jan 15, 2009). I have also claimed that one of the reasons for this might be the “innovative” debt structures seen over the last couple of years.
Now, the default of LyondellBasell (the default I discussed in my blog The first iTraxx default some weeks ago) has shown exactly how low recovery rates can go, even in cases where the firms involved are major ones (and even included in the iTraxx indicies). The recovery rate set in the CDS-auction of LyondellBasell were a meager 2%! Now, that’s certainly low, the historical average is around 40% for loans and 85 % for bonds!
For me, at least, this comes as no surprise. In fact, in January this year I said in my blog Weak covenants as a cause of lower recovery rates in the near future! – Part III, quote:
“...I certainly still think we will see a dramatic number of record-low-recovery defaults this year.”
OK, “en fjäder gör ingen höna”, as we say in Sweden, but I stand firm in my predictions.
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Needless to say, ones predictions about future recovery rates will have a significant effect on ones loss-estimates and consequently on ones decisions to buy/not buy corporate bonds. A lot has been said, lately, regarding the attractiveness of corporate bond yields. Even I expect these, historically very attractive, yields to come down somewhat during the course of 2009-10 but I am not so certain that they are obvious bargains. If recovery rates remain as strikingly low as I have predicted for some time, and as exemplified by the LyondellBasell bankruptcy, then what at first looks like a bargain will instead turn out to be a bummer!