The Time Bomb in Corporate Debt

No surprise here: As the recession grinds on, more companies are falling behind on their debt payments. The default rate tops 11%, up from 2.4% last year—and could peak at 12.8% by the end of the year, the highest ever, according to credit rating agency Moody's Investors Service (MCO). But what's worrying economists more is that the rate could remain stubbornly high for quite a while. "Be prepared for a multi-year period of high defaults," says Louise Purtle, a senior analyst at CreditSights. "We're going to see peaks like a mountain range."

That's a departure from the usual pattern in recessions, even severe ones. Historically corporate defaults spike as downturns ease, then fall back to more normal levels. But the recovery may be delayed this time around. Companies aren't cleaning up their balance sheets that much, and current debt levels are unsustainable. The debt overhang could hamper the economy for years to come.

The problem, of course, is that corporate borrowers binged on credit during the boom years. Now U.S. companies carry some $1.4 trillion in high-yield bonds and loans, a burden that's nearly triple the amount in 2001, according to Standard & Poor's Leveraged Commentary & Data (MHP), a research group. More than half of the debt comes due in the next five years.

Already the pile of debt is forcing companies to make painful choices that will reverberate through the economy. Consider newspaper publisher Gannett (GCI), which has $3.5 billion in debt and reported $1.1 billion of cash flow in the past 12 months. Amid slipping sales, the company is slashing payroll and cutting its dividend. While Gannett has the money to meet interest payments, it has sharply reduced investments for growth. Says a Gannett spokeswoman: "In the first quarter we paid down debt."

It's proving more difficult to unwind debt today than in previous downturns. Distressed companies can't easily sell assets to pay off debt amid the harsh dealmaking environment. And many owe more than their underlying assets are worth—not unlike homeowners who owe more on their mortgages than their homes would fetch on the market. Meanwhile, big banks and other financial firms, still battered and bruised from the financial crisis, don't have the strength or the will to refinance all that debt.

Without many options, more borrowers will find it tough to meet their financial obligations. So far this year, 128 companies have defaulted, including General Motors, clothier Eddie Bauer (EBHIQ), aerospace company Fairchild, and paper maker Bowater. Those four companies have filed for bankruptcy. S&P figures an additional 207 are "vulnerable" to default. Among the distressed: auto suppliers Accuride (AURD) and American Axle & Manufacturing (AXL), retailers Claire's Stores and Saks (SKS), as well as real estate franchiser Realogy, the owner of the Century 21 and Coldwell Banker brands.

Companies are doing everything they can to avoid default. Some have worked out "amend and extend" deals, which postpone the due dates on their loans. For example, video rental chain Blockbuster (BBI) was able get an extra 13 months to pay off a bank loan. In exchange, the company agreed to pay an additional 8% in interest. Lenders are being cautious. Accuride, which makes chassis for trucks, got a mere 45 days to meet financial tests that are a requirement of its loans. Accuride declined to comment.

"Band-Aid" Relief

Other companies have stays of execution built into their bonds already. During the boom years, more than 60 companies issued bonds that allowed them to put off interest payments for the life of the bond. In a sign of distress, at least 23 companies are using that option today, including casino giant Harrah's Entertainment, chipmaker Freescale Semiconductor, and retailer Neiman Marcus. Neiman Marcus declined to comment. Harrah's and Freescale didn't return calls.

But such moves provide only temporary relief. The arrangements "are like Band-Aids," says M. Christopher Garman, editor and publisher of Leverage World. They "don't solve the basic problem" of too much debt. Instead, companies are postponing the inevitable, which weighs down their balance sheets and drags down the broader economy.

Look at the recent spate of debt modifications. In the first six months of 2009, nearly 40 companies made special deals with creditors to trim their debt. Generally, only a handful of companies make such arrangements each year. And they're often unsuccessful, according to a recent study by Edward I. Altman, a professor at New York University's Stern School of Business: About half the companies that got these sorts of concessions end up filing for Chapter 11 anyway. "It's a disturbing statistic, because it implies either that their problems were more than debt or that the reduction in debt wasn't enough," says Altman.

Chapter 22

The trend persists today. In May 2008 amusement park operator Six Flags (SIXFQ) persuaded a group of creditors to reduce its debt by 5%, or $130 million. The move gave Six Flags some breathing room for its busy summer season and a chance to improve its fortunes. But the company's problems proved insurmountable. Six Flags filed for bankruptcy in June 2009.

Media conglomerate Charter Communications filed for bankruptcy in April after lenders modified its debt several times. "Most of the widely used out-of-court restructuring options, such as debt exchanges or refinancing, do not solve the ultimate problem" of excessive leverage, says Bradley Rogoff, a bond strategist at Barclays Capital (BCS). Six Flags declined to comment.

The economy may be better off if companies filed for bankruptcy at the outset. Sure, Chapter 11 isn't a cure-all. Many companies that get out of bankruptcy return to court in what experts sarcastically refer to as Chapter 22.

But the proceedings do a better job of cleaning up the books and reducing debt loads. Spectrum Brands, the maker of Rayovac batteries, Tetra fish food, and other consumer products, is set to emerge from bankruptcy in August with one-third less debt than when it filed in February. That's twice the relief that companies typically get from creditors out of court. Bankruptcy "often yields better results than just tinkering with the debt and keeping the same management," says Garman of Leverage World. "The only way to really repair a balance sheet thoroughly is Chapter 11." And the more debt that's wrung out of the system, the stronger the overall recovery.

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