Thursday, April 03, 2008
the coming corporate bankruptcy boom?
If the debt markets are to be believed, companies could be in at least as much trouble as they were in the previous two downturns, in the early 1990s and at the start of this decade, after the dotcom bubble burst. A leading indicator is the spread between yields on speculative “junk” bonds and American Treasury bonds. A year ago, the spread was only about 280 basis points; the long-term average is around 500 points. This month the spread exceeded 800 points for the first time since March 2003, reaching 862 on March 17th.
FridsonVision, a research firm, publishes a default-rate predictor based on the percentage of bonds trading with a spread of at least 1,000 basis points. On March 19th this was forecasting a default rate on high-yielding American corporate bonds of 8.55% by the end of February 2009, compared with Moody's forecast for American bonds of 6.8% for that date.
Martin Fridson, the firm's founder, admits this forecast is risky, because it relies on prices set in a market that has been hit by the liquidity crisis. Indeed, some contrarians believe that today's corporate-bond spreads say more about the shaky health of the financial markets than they do about the condition of corporate borrowers. As liquidity returns, they predict, corporate-bond prices will soar, making this the buying opportunity of a lifetime.
Mr Fridson concedes that the difference between corporate-bond spreads and actual default rates is unusual and hard to explain: on the previous occasions when spreads have exceeded 800 points, the default rate was already 9.43% in 1990 and 5.44% in 2000. That said, the huge amounts of “covenant lite” debt issued in the credit boom of 2005-07, which gives lenders much less power to demand their money back than in the past, may have delayed the moment of default for many underperforming firms. So FridsonVision looked at the ten firms in which spreads exceeded 1,000 points by the smallest amounts. If these were merely victims of irrational pessimism in the market, they ought to be in relatively good shape. In fact, the analysts found plenty of reasons to worry. The companies included household names such as Beazer Homes, Ford and Rite Aid, all of which are “exhibiting classically distressed behaviour of downsizing amid recurring losses.”
A look at the firms with distressed debt shows that problems are rapidly moving beyond the long-term sick (airlines, cars) and the industries immediately affected by the crisis (home builders, mortgage lenders, monoline insurers). Craig Dean of AEG Partners, a restructuring-advisory firm, says he is now seeing troubled companies in retailing, restaurants, manufacturing and food processing.
more from yves smith. a surge in corporate bankruptcies comports well with my impression of the last few years of very low corporate bankruptcy rates. questionable operations were sustained by the same evaporation of underwriting standards in lending as was seen in residential mortgages (though perhaps to a lesser excess). allowed to pile on more and more low-interest-rate debt, rather than be driven to bankruptcy by nervous creditors, these companies are now a backlog of defaults held back by a dam of easy credit. that dam is now broken, and recession is imminent -- ergo, a flood is coming.
recent improvement in corporate credit default swap metrics have been explained a massive short squeeze, noting that:
... cash bond indices had barely moved in recent weeks, with many bonds still trading at very wide spreads.
Illiquidity in cash bond markets may contribute to their divergence from credit derivatives, but some analysts say these bonds may still give a truer picture of investor appetite for risk....
but accrued interest notes that things have, for whatever reason, thawed a bit in credit markets for the first time in months. to be sure, it was seen earlier that things had got overdone and a rally was overdue. if there is a considerable liquidity-driven mispricing in debt instruments, it should become evident fairly soon as something like liquidity returns.
this situation is very different from the mega-caps in general, many of whom are carrying massive cash balances and are in little danger (though some, like ford, are in a boatload of trouble). rather, the bulk of the danger lays in the mid- and small-cap sectors. in some ways, while growth has not been nearly so spectacular as the financial and household varieties as ft's martin wolf notes in this important article, corporate debt seems to have concentrated at the lower-quality end of the corporate scale.
as the economist's graph shows, there may be a lag of a few quarters before defaults amass in earnest. but, when they do, i suspect the rate will quickly jump to double digits and unemployment become a serious problem in the united states.