Only the Strong Shall Thrive

Financially sound companies find gold in credit mayhem even as weaker players fear the game is up.

Credit spreads narrowed on lower-grade securities as credit eased, meaning that investors were willing to accept little reward for taking extra risk. For example, spreads on high-yield corporate bonds, which were 818 basis points in March 2003, narrowed to 282 basis points in early 2007, according to the Securities Industry and Financial Markets Association. During the same period, spreads on subprime mortgages also shrank. As long as real estate prices kept rising, all was well.

But as real estate prices began to fall and subprime-mortgage defaults rose in late 2006 and early 2007, securitized bonds containing subprime mortgages collapsed, shaking investor confidence. By summer, investors were rejecting low-yielding, risky debt that carried lax issuance standards, including around $350 billion in leveraged financing, mostly for LBOs, basically shutting down the deal machine. As the market struggles to regain its footing, yields for lower-grade investments are climbing as investors demand more pay for risk. That trend is expected to continue. “As much as we thought it was different this time, it was not — there will be a reassessment of risk,” says Art Hogan, director of global equity product at Jefferies & Co.

Rising interest on high-yield debt endangers highly leveraged firms. Businesses with lower credit ratings tapping the high-yield bond market are paying an average of 2 percent more than they did in early summer, according to Fitch. Spreads have widened to 456 basis points over 10-year Treasury notes as of early September, versus 240 basis points in early June.

Higher interest rates make it more difficult for speculative-grade corporations to refinance by issuing new debt. This could well kick off a wave of defaults and bankruptcies. Edward Altman, director of the credit-and-debt-markets program at New York University’s Salomon Center, Stern School of Business, says high-yield debt issuers typically begin defaulting in the second year after issuance, and nonperformance accelerates in the third and fourth years. That scenario doesn’t take into account outside conditions such as the economy and liquidity, he says. High liquidity, for example, can keep such companies propped up, as it did during the credit bubble, but with credit tighter, more bankruptcies are likely, Altman says.

Moody’s predicts that the speculative-grade corporate default rate will rise from about 1.5 percent to 4.1 percent in the coming year. And the number could climb to 5.1 percent by August 2009.

Bankruptcy rates are rising, too. The American Bankruptcy Institute reports a 45 percent surge in business bankruptcies in the first half of 2007 from the same time in 2006. But the 12,985 business filings of the first half are still historically low, about 30 percent down from the comparable period in 2004.

Waiting for Distress

Distressed-debt and other investors are ready. “We have been waiting for this,” says Philip Von Burg, principal of New York–based Monomoy Capital Partners, which invests in financially underperforming firms. Von Burg expects marginally higher financing costs, but because his firm has a conservative approach to debt, he believes bank funding will still be obtainable.

So far, the companies most hurt by banks’ tightening have been those connected to housing, like Irvine, California-based Standard Pacific Corp., a home builder that also provides mortgage financing. In late August, the company took steps to avoid defaulting on a tangible net worth covenant it had with its lenders. It entered negotiations with its banks to reduce its credit facilities and renegotiate its leverage ratio. In a Securities and Exchange Commission filing, the company said it planned to reduce a revolver to $900 million, from $1.1 billion, and cut a term loan to $225 million from $250 million.

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