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Regimes, Recoveries and Loan Ratings: the importance of insolvency legislation

by Faith Bartlett of Fitch/IBCA

October 1999

Executive Summary: This article considers the impact of insolvency regimes on the rights of secured creditors and therefore on the ratings of secured loans. Most secured loans are to sub-investment grade or 'leveraged' companies, as opposed to investment grade companies, which typically borrow on an unsecured basis. The four jurisdictions covered in this study include the three countries that have had the greatest number of LBOs ('leveraged buyouts') and therefore the most 'leveraged loans' in Europe, namely France, Germany and the UK. These insolvency regimes are then compared to the regime that exists in the US. It is intended that this study will be the first in a series reviewing the impact of the various insolvency regimes in Europe on loans. The starting point for a loan rating is an entity or unsecured rating, which measures the likelihood that the borrower will default on its debt. The methodology used to arrive at the entity rating is the same as that employed to rate unsecured bonds.

The loan rating is then 'notched up' from the entity rating based on the key structural characteristics of the loan and the likely level of recoveries in a distressed scenario. For example, a senior secured loan to a B quality company could be notched to B+, BB-, or even BB, based on the composition of the company's capital structure, the value of its security and the covenants contained in the loan documents. A loan rating is an indication of the expected loss that an investor can expect to experience on the asset. The expected loss is a function of the probability of default and the severity of loss. The expected loss on a loan is significant to investors who often have the option to invest in either the loan or the high yield bond of a particular issuer. Since high yield bonds have higher coupons than loans, the expected loss on a loan must be low enough to make it a better "relative value" compared to a bond from the same company. In the US, Fitch IBCA research has shown that the recovery rate on leveraged loans is 80%, on average, compared to 40% for high yield bonds, thereby making the expected loss on loans significantly lower than that for bonds.

As a result, leveraged loans have become an extremely popular asset class among US investors in recent years and should also develop a significant investor base in Europe as the various insolvency regimes and their impact on default and recovery rates become better understood.

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