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Maturities may be stretched out, but many companies are still saddled with too much debt.
Vincent Ryan, CFO.com | US
December 10, 2009
High-yield bond defaults in the United States fell in the second half of 2009, according to a report released this week by Fitch Ratings, and are projected to decline substantially by the end of 2010. But there's still plenty of risk that many noninvestment-grade firms will default on debt next year and the year after, especially if the U.S. economy does not make a strong recovery, Fitch says.
After 103 noninvestment-grade companies defaulted on $79.7 billion of bonds in the first half of 2009, reports Fitch, 42 issuers defaulted on $36.8 billion of issuance from July to November. Despite the slower pace, the year-to-date default rate rose to 13.6%. When defaults from December are added in, Fitch expects the full-year default rate to be just shy of its forecast range of 15% to 18%.
For 2010, Fitch projects high-yield defaults will continue to decline, to a range of 6%–7%. (The long-term average annual rate is 4.7%.) Standard & Poor's recently lowered its 12-month-forward baseline projection to a similar range, largely because of declines in funding costs for corporations, the reopening of the bond markets, and the abatement of volatility. S&P admits that it "had stated our expectations for a swath of defaults to occur in the first half of 2010. But now, we expect many of the defaults might be postponed to later quarters beyond the 12-month forecast horizon."
Postponed, but not eliminated. Some companies have merely pushed out the maturities on their debt or received covenant amendments instead of restructuring and rightsizing their balance sheets, say restructuring experts. Therefore, more so than in prior recessions, the sustainability and strength of the economic recovery will be a critical determinant of whether speculative-grade companies can survive in 2010 and beyond.
Leverage overall remains high, Fitch reports, because many defaults in the past year have been in the form of out-of-court debt exchanges — deals that offered some debt relief but didn't reduce debt to the extent that a formal bankruptcy would. Prior Fitch studies show that companies that declared bankruptcy from 2000 to 2006 emerged with just one-third of their prebankruptcy debt. But after undergoing debt exchanges this year, many ailing companies are still carrying plenty of debt, "evidenced by the fact that most remained rated 'CCC' or lower following the exchange," says Fitch.
At the end of November, CCC-rated bonds, which carry substantial credit risk, still represented 30% of the U.S. high-yield market. More than a third of that $230 billion in outstanding bonds is associated with companies that have already done some kind of debt exchange, says Fitch. A reopening of the bond market for new issuances also rescued many noninvestment-grade credits that were candidates for bankruptcy. Noninvestment-grade firms were able to tap the bond market for $186 billion in new issuance as of the end of November. More than 80% of those dollars went to refinance existing debt, including some in bank-loan or revolver form.
"A concern going into 2010 is not only the risk of new defaults but also a heightened risk of serial defaults," says Mariarosa Verde, a managing director at Fitch Credit Market Research. "If growth proves weak, some of the debt-restructuring measures adopted over the past year may have only been successful in helping companies defer rather than avoid bankruptcy."
The market seems to be pricing in expectations of further failures. After falling for most of 2009, credit-default swap (CDS) spreads for noninvestment-grade firms have begun to plateau, as evident in the performance of the Baird CDS Index, a proprietary index of 36 CDS contracts for the noninvestment-grade debt of nonfinancial companies. While the index dropped 4% in November, it is still six times its base level of January 31, 2006. "The index is signaling that we're not out of the woods," says William Welnhofer, a managing director of investment banking at Robert W. Baird & Co. "There just hasn't been the evidence of an operational turnaround. There is a feeling that leverage is still pretty high in relation to operating income. Fundamentally, companies that were overlevered six months ago are still overlevered."
Part of the problem is that banks are not being aggressive enough in dealing with their distressed-loan portfolios, say some restructuring experts, due to an unwillingness to book loan losses or a lack of necessary capital to absorb them. "It's called 'lend and pretend,'" says Richard Lindenmuth, a managing director at Boulder International LLC, a management consultancy. "I've had a bank tell me that it hasn't done a workout in eight months. In this economy that's not abnormal, that's a fantasy."
"It's a 'kick the can down the road' mentality on the part of regulated financial institutions," says Welnhofer. "If you believe that your business and the capital markets can't get worse, there is probably no downside. But things can get worse, and sometimes they do."