Defaults on the Rise

Bond defaults have already set an annual record this year, and the next two years could see an even thicker flurry of defaulted junk paper, distressed pros said.

According to Standard & Poor's, the 55 defaults in the first half of 1999 already exceed the number of defaults for all of last year. And the $20.5 billion in defaulted debt almost doubles last year's dollar amount. Both the number of defaults and the dollar amount will be records, according to a Standard &Poor's report released recently. As of two weeks ago, the number of defaults hit 71 on $27 billion worth of paper, a new record.

Lee Buchwald, a managing director at Chanin Kirkland Messina, predicted that the default trend will continue unabated, at least through the end of the year. The last two years were strong ones for junk-bond issuance, and some of that backlog is ripe to go bad, he said. Industries facing defaults include natural resources, retail and commodities, especially steel, he said.

The 1999 default rate is actually normal, argued T. Rowe Price Recovery Fund Managing Director Herb Stiles. Statistically, the last three or four years have seen a lower-than-average number of defaults and this year all the junk issuance of the past two years is starting to manifest itself, he said. According to Stiles, about 30% of the dollar amount of junk bonds in any given year of issuance will default at some time in the life of the bond, so the market should expect the default percentage to increase, he said.

There have been 16 defaults since July 1, totaling roughly $7 billion, said Leo Brand, an associate director at Standard &Poor's. The last two weeks have seen Stuart Entertainment Inc. and The Claridge Hotel and Casino Corp. default on $100 million and $85 million in bonds, respectively.

Six energy companies have defaulted so far this year, including Coho Energy, Inc., which defaulted on $400 million and Forcenergy Inc., which had a $375 million issue crater the same month.

But the energy sector seems to be bouncing back, Brand said. Oil prices have seen the bottom of the barrel and have risen substantially over the past year, he said. Whether the recovery is going to happen quickly enough to save some of the smaller energy companies from defaulting remains to be seen, he said.

The default situation will impact even financially sound companies, Buchwald said. Primary sources of capital are becoming more conservative, to the point where companies that previously had an easy time attracting capital will find the market less accepting if they need to refinance debt and are edging towards default, he said.

Of course, what's bad news for bondholders can be good news for distressed investors. Bill Featherston, a managing director at Greenwich High Yield LLC, said that there are clearly more choices this year due to the increased level of defaults. But there is an overabundance of marginal companies with bad balance sheets and flawed business plans that vultures wouldn't touch, he said. There are still many good values in energy companies engaged in exploration and production, and even the steel industry, hammered by Asian competitors, will bounce back after restructuring, he said.

A good indicator of the state of the junk bond market is the spread over treasuries, said Gordon McCormick, managing director at M.J. Whitman. Single B minus issues, which comprise 41.4% of the bond market, have a current yield of 11.53%, more than 6% higher than Treasury bonds, he said. This spread, historically only 3%, illustrates a "fear of default index" on junk bonds, he said.

And be prepared to see many more defaults in the future, commented Jeff Werbalowsky, managing director at Houlihan Lokey Howard & Zukin. There have been extraordinarily few defaults over the last few years, he said. "We've seen a few scratches, but we haven't seen any real blood yet," he said of this year's defaults. A downturn in the economy, or a spike in interest rates - even the specter of Y2K - could bloody the bond market further, he observed.