Risky business?

Global debts reached a record-high $237tn at the beginning of the year, prompting the International Monetary Fund to voice concerns in its latest Global Financial Stability Report. These centered on the risk that increasing corporate debt levels would lead to riskier investments – precipitating “a severe downturn or financial sector stress over the medium term”.

It’s a warning shot for banks and corporates alike as companies hurry to raise capital in the quest for greater growth and banks hasten to lend in an environment of greater liquidity.

It also poses an important question: what happens if corporates start defaulting on this debt? Global Credit Data’s latest report, which analyses Loss Given Default (LGD) – a common risk metric that measures the percentage of money lent that is never recovered in the case of a borrower default – can start to offer some answers. For corporates worried that these warnings will quell banks’ appetite for lending, it makes for happy reading – highlighting that, on average, banks recover 75% of defaulted corporate debt, and, in most cases, they recover almost all of it.

What’s more, there are several basic steps that corporates can take to reassure their bank that their money is secure even in the case of default – itself an unlikely occurrence, with defaults accounting for just 1% of the typical bank’s loan book.

High recovery rates across the board

The overall recovery rate of 75% certainly is a reason for optimism. Of the 1% of corporate debt that results in a default, 75% is recovered. In other words, banks recoup 99.75% of corporate debt – in addition to the returns they see from loans that are repaid in full, on time, and with interest. This tends to play out as an “all or nothing” scenario: rather than recovering around 75% of each individual defaulted facility, banks tend to recoup almost 100% from the majority while 10% of defaulted loans result in a loss of 80% or more.

Bank recoveries are also consistent across various regions. Europe and North Africa register very similar figures, while Africa and the Middle East (which boasts slightly lower LGD) and Asia (slightly higher) show some variation, although this is likely due to inconsistencies in the make-up of the sample data, rather than genuine statistical significance.

Data for Asia and Oceania, for instance, is comprised by a large number of different countries – most notably Australia, South Korea and Hong Kong. The issue is that each country is unique from an economic and legal perspective and therefore has a different LGD outcome. The country-level LGDs for Australia, Japan, South Korea and New Zealand are more or less in line with the European and North American data, but other countries show higher LGDs – pushing up the region’s average.

Findings for the African and Middle Eastern region, meanwhile, are based on a much smaller data set compared to the other regions. A large portion of the data comes from South Africa, which shows a much lower LGD on average than other African or Middle Eastern countries – again potentially skewing the results. Nevertheless, there is certainly no evidence that African and Middle Eastern debt is subject to greater levels of LGD – good news for corporates in the region.

A word of warning, however. Cash-rich corporates looking to buy up other companies’ debt with surplus liquidity should be aware that they are unlikely to see the same recovery rate as banks. To achieve anything like the 75% figure, they would need a diversified portfolio – made up of hundreds or even thousands of loans, across different countries, regions and industries.

Sign of the times

LGD data also varies over time in a way that suggests a relationship between it and the state of the global economy (see the LGD Downturn Report, issued in November 2017). As expected, the data set shows that default rates are inversely proportional to GDP growth rates, but, perhaps surprisingly, LGD rates are not correlated in the same way.

Indeed, though LGD does appear to be correlated with global GDP growth, it develops out of phase. The reference data set for the LGD report shows that LGD rose well ahead of the financial crisis (as observed by GDP growth and default rates) – reaching a clear peak in 2008 before dropping off during the crisis and settling down before default rates had returned to normal.

It seems, therefore, that there is a clear link between macroeconomic downturns and a rise in LGD – though it’s harder to attribute this link to any systematic factor. The data set currently covers defaults up to and including 2014, so we cannot say whether the last few years have seen an uptick in LGD that may presage a downturn in macroeconomic fortunes.

Seniority and collateral drive recovery

A key finding of the report is the importance of two factors in determining the likelihood and extent of loss for banks in the case of corporate default. The first of these is seniority: corporates can look to senior debt to convince lending banks that their investment is safe – particularly if the loan is not secured.

Data shows that senior unsecured LGD is significantly lower than subordinated unsecured debt – with banks recovering 73% of senior unsecured debt, against only 60% of subordinated unsecured. This provides strong evidence that seniority of debt plays an important role in bank recovery – making senior debt issuances from corporates a more attractive proposition.

Similarly, collateral also makes a significant difference to LGD – with an average LGD of 23% for secured debt, compared to 28% of all unsecured debt. This supports common bank lending policies, which assume that taking collateral will improve the bank’s lending position compared with an unsecured loan – a factor that is all the more important given the present concern surrounding mounting levels of corporate debt.

And with the risk of non-recovery following default rising to 40% when a loan is neither senior nor secured, providing these guarantees will be almost essential to securing favorable funding if the lending climate tightens in the coming months or years.