Secured Bonds Are More Likely To End Up Distressed – Fridson

High-yield market guru Martin Fridson’s latest statistical deep dive this week reveals a strange paradox: secured bonds are much more likely than unsecured bonds to end up trading at distressed levels. Fridson, chief investment officer at Lehmann Livian Fridson Advisors, finds that secured bonds account for 40.2% of distressed bonds (bonds trading with risk premiums of at least 10 percentage points over comparable Treasury bonds) outstanding even though they make up just 18.6% of the overall high-yield bond universe. He says 8.82% of outstanding secured issues are currently distressed, versus just 3.04% of senior unsecured bonds, making secured bonds 2.9 times as likely to end up distressed.

Fridson notes that secured bonds still enjoy better recoveries (58.8 cents on the dollar, on average) than senior unsecured bonds (38.9 cents) in the event of a default, but that bonds can suffer big price losses even without a default, as happened in 2007. Here’s Fridson, writing for S&P Capital IQ:

Somewhere there may be investors who do not care one bit if a bond takes a 30-point hickey, as long as they know they will be comparatively well off if the issuer eventually goes bankrupt. Over here in the real world, price declines do matter. Therefore, the goal of high-yield management is not merely to avoid defaults but also to avoid bonds that fall to prices indicative of a high probability of default….

Overweighting secured bonds is a good way to fail in that objective, judging by the distribution of distressed and non-distressed issues…. Looking for good investments among the secured bonds is a better way of encountering distress than of avoiding it.

The companies that must make the concession of offering security to bondholders are, on average, weaker credits than those that do not. By this reasoning, secured issuers’ bonds are more likely than unsecured issuers’ bonds to wind up at deep discounts, even if default never enters the picture.

Fridson says evidence of this pattern is widespread enough that it’s “no statistical fluke.”

As an aside, he notes that subordinated bonds are also over-represented in the distressed universe, representing 7.2% of the distressed index versus just 3.3% of non-distressed bonds. Here’s his explanation for that:

Subordinated issues’ proneness to distress may indicate that companies with complex capital structures tend to be weak credits. (That conjecture could apply to secured bonds, as well.) None of the currently secured, distressed bonds is a financial, eliminating one possible means of explaining away the results as a statistical fluke. As a point of information, subordinated (including junior subordinated) bonds account for just 4.4% of the BofAML High Yield Index.