credit markets: don't worry, be happy...
Put another way, more junk-bonds defaulted in the second quarter than were issued."
July 10, 2000
Junk-Bond Defaults Are Up Sharply,
Raising Concerns of a Credit Crunch
By PAUL M. SHERER
Staff Reporter of THE WALL STREET JOURNAL
Even some of the optimists on the outlook for junk-bond defaults are saying: Never mind.
Donaldson, Lufkin & Jenrette Inc., the biggest
underwriter of junk or "high-yield" bonds -- which until
recently was preaching a don't-worry gospel on defaults
-- now isn't so sanguine. It says the U.S. is in a credit
crunch, which means companies unable to raise funds
from increasingly cautious lenders are being forced into
default.
"We see a systematic crowding out of more risky assets, [and] smaller issuers [aren't] able to
access the capital markets," says Sam DeRosa-Farag, DLJ's director of global high-yield
portfolio strategy. "That is the classical credit crunch." Only $8 billion in junk bonds were
issued in the second quarter, down from $31.4 billion in the same period of 1999.
Put another way, more junk-bonds defaulted in the second quarter than were issued. About $9.4
billion in bonds defaulted in the quarter, issued by companies ranging from cinema operator
United Artists Theatre Co. to waste-management company Safety-Kleen Corp., along with
several companies that were originally investment-grade issuers, such as bus operator Laidlaw
Inc.
Prominent junk-bond researcher Edward I. Altman at New York University's Stern School of
Business, who at the start of the year had expected 3% of junk bonds to default in 2000, now
expects several more quarters of high defaults after the first half ended with an annualized
5.22% default rate.
More Trouble Predicted
"It appears that the recent spike in default rates has some time to go before the excesses of
new-issue, low-quality debt in the mid and late 1990s will be flushed out of the system," says a
new report by Prof. Altman. "We can probably anticipate at least several quarters more of
continued high default levels." The report was published by Citigroup Inc.'s Salomon Smith
Barney, where he serves as a consultant.
The growing pessimism on defaults comes as the U.S. shows signs of approaching the end of a
credit bubble. After years of soaring corporate and consumer debt, a series of interest-rate
increases and growing caution on the part of lenders have begun to squeeze shaky borrowers.
Meanwhile, some key indicators of future
defaults have turned downward. Mr.
DeRosa-Farag notes that the ratio of
credit-rating upgrades to downgrades has
dropped sharply, from a historical average of
1.2 upgrades per downgrade to 0.65 last year
and 0.4 last month. "The trend is alarming us,"
he says.
In another bearish sign, about 17% of junk
bonds are trading at distressed prices,
compared with 9% at the end of 1999 and 3%
at the end of 1998, says Prof. Altman. He
defines "distressed" as those bonds trading at
yields of 10 percentage points or more higher
than Treasury issues. "A 17% distressed debt
proportion is somewhat ominous, since this
category makes up the vast majority of 'raw
material' for future defaults," his report says.
An important driver of the default surge is the
recent tightening of credit standards by banks
that have become less willing to continue
supporting weak companies. "They're being
much tougher with the marginal client," Prof.
Altman says in an interview. "As a result, these
companies can't refinance, they can't get
waivers. They wouldn't have failed a year ago,
but now they are."
Caution in Bond Market
Bond-market investors have become more cautious, too. While in 1996 and 1997 they were
willing to lend companies up to six or more times their cash flow, "today if you have more than
five times [debt to cash flow], you'd have difficulty accessing the market," Mr. DeRosa-Farag
says.
Though this means that today's issuers should have lower future default rates, the new caution is
troublesome for companies that raised money in the mid-1990s. "Credit quality [of new
issuers] has been improving so dramatically that riskier issuers who were able to access the
market three or four years ago can't access the market today without significant improvement in
credit statistics," says Mr. DeRosa-Farag. "All of the sudden, you're considered too risky to
finance. In effect, you're shut out of the market."
Whether the U.S. is in a credit crunch depends on your point of view. "When a lot of these
deals came to market there was easy access to capital, probably because people's appetite for
risk was higher," says David T. Hamilton, an analyst at Moody's Investors Service. "Bank
lending standards have come back to earth, but I don't necessarily think they are overly tight."
DLJ until now had seen defaults as a receding problem. Using an annualized quarterly default
rate, DLJ last month said defaults had peaked in the second quarter of 1999 at 5.3%, falling to
3.25% in the first quarter of this year. But in the just-ended second quarter, DLJ now says,
defaults surged to an annualized 5.58%. DLJ still predicts that defaults will decline, but less
quickly than it had expected; on a 12-month trailing basis, it sees defaults falling to 3.2% this
year from 4.1% last year, where it previously expected a decline to between 2.5% and 2.8% this
year.
Effects on Specific Industries
Last year, analysts explained away part of the surge in defaults by blaming them on
industry-specific factors hitting energy and health-care companies, rather than system-wide
problems. Energy companies were hurt by low commodity prices in 1998 and early 1999, while
a cut in U.S. government Medicare reimbursement levels helped send a slew of healthcare
companies into default.
But recently, the defaults have been spread out across other industries. The defaulters in the first
half include 17 in "miscellaneous industries," eight in general manufacturing, five in retail, and
four each in financial services, leisure/entertainment, health care and transport, Prof. Altman's
study says. Energy companies accounted for only 0.7% of defaults in the first half of 2000,
down from 17.8% last year, while metals and minerals fell to zero from 7.7%, DLJ says.
"We have a decline in cyclical defaults," but that has been replaced by casualties of a credit
crunch and by "heightened competitive issues" for individual companies, Mr. DeRosa-Farag
says.
In raising their default estimates, DLJ and Prof. Altman move closer to the outlook at Moody's,
which for months has been far more bearish and is becoming more so. Moody's model now
predicts that defaults will soar to 7% at year end and 8.4% by next June, up from 5.4%
currently. ( Moody's measures defaults differently, so that rates aren't directly comparable ) .
Despite the growing default gloom, both DLJ and Prof. Altman argue that returns for
junk-bond investors over the next year could be strong. "There's going to be a lot of money
made by buying near the peak" of defaults, Prof. Altman says. The default rate peaked at 10.3%
in 1991, but returns peaked that same year at 43%.
That said, some pundits also called the bottom a year ago, but returns so far this year have been
negative 1.19, DLJ says. |
