Junk Bonds: The Default Dilemma
On Aug. 3, Iridium World Communications Ltd., a satellite mobile-phone company that raised more than a billion dollars of high-yield paper over the past two years, defaulted on its debt. But the event was far from isolated. Among the other high-profile companies that have recently turned their backs on debt obligations are funeral-service operator Loewen, restaurant chain Planet Hollywood, and discount clothing retailer Loehmann's.
In the first seven months of 1999, 107 companies defaulted on their debt, to the tune of $28 billion. That compares with 75 defaults in the same period in 1998, worth $11 billion, according to Moody's Investors Service. Today's 5% default level doesn't reach 1991's 10%, the height of the Michael Milken era. But the level now is near 1989's 6% default rate, which signaled the beginning of the junk-bond debacle.
How can defaults be rising against the backdrop of a strong economy, the longest bull market in history, and a hot initial public offering market? "The increase in defaults in the high-yield market is one of the most controversial issues in the market right now," in terms of why it is happeninG and how long it will last, says Kingman Penniman, director of research at KDP Investment Advisors Inc., a high-yield debt research firm based in Montpelier, Vt.
SMOKING GUN. "What we're seeing, in part, is a hangover from having been too generous with the supply of credit," says John Lonski, chief economist for Moody's. In the three years ended in 1998, there was a 66% increase in junk-bond issuance from the previous three years. "If more people are smoking heavily, there will be more lung cancer," says Lonski.
Nicholas D. Riccio and Leo Brand, authors of a Standard & Poor's Corp. study, say that in the third quarter of last year, "47% [of the defaults] can be traced to the Asian and Russian crises," says Brand. With a worldwide bottoming of commodity prices, any company whose revenues are dependent on those products is vulnerable, as is the case with steel and energy companies.
Further, many companies skipped latter-stage venture-capital financing, and without strong operating histories behind them are "extremely vulnerable companies that would default at the first sign of trouble," says Brand.
Loose bank lending is also a factor. In the past few years, banks have been co-dependent partners to many companies using junk debt. Many financial institutions have been more than willing to renegotiate debt covenants to ailing businesses as long as the debtors feel they can get the cash elsewhere, typically equity from an initial public offering. But as the IPO market has become deluged with dot.com offerings, many non-Internet companies no longer have that backdoor method of paying down debt.
FINANCING DREAMS. "For a long time, high-yield financing was used to finance terrific companies with great cash flow," says Neil Subin, president of Trendex Capital Management, a money-management firm based in Boca Raton, Fla. "But in the past few years, substantial amounts of money have been raised to support what amounts to dreams--companies with no revenue, no cash flow, but terrific projections."
It seems investors are beginning to get nervous. There have been redemptions from junk-bond mutual funds during the past four weeks totaling more than $1.5 billion, according to AMG Data Services, a mutual-fund tracking company. This outflow represents the fourth consecutive week of redemptions.
This follows a year-long trend in which companies are finding it more difficult to access the high-yield market. Already, issuance is down 25% so far this year, compared with new debt issued last year. And investors are demanding higher yields to compensate for their risk. For instance, from 1995 to 1997, the average junk-bond yield was 3 1/4% above comparable Treasuries, vs. 4 1/4% today. Some investors worry that even those yields still don't reflect the level of risk in high-yield bonds today. "Eventually, there will be a flight to quality," says Brand, pushing up spreads even higher.
One thing seems clear: Rising stock prices and rising defaults can remain in tandem only for a relatively short time. Something has to give.