Defaults Creep Up As New Century Dawns

At the outset of the decade, the high yield market was nearly knocked off its feet by the meltdown of junk powerhouse Drexel Burnham Lambert, rising oil prices and a lurking recession.

The default rate, as a result, hit an all-time high - soaring beyond 13% by some estimates - in a market with an average default rate of 3.4% since 1970.

Even as the junk market stabilized over the course of the 1990s with more players on both the buyside and sellside of the game, and default rates sinking to record lows, the decade ended with the default rate creeping upward throughout 1999.

The year started with a speculative-grade default rate of about 3.4%, and crept up to 6.8% by late October, according to Moody's Investors Service.

"What happened in 1999 is in many respects more important or as important as what happened over the previous ten years in terms of interpreting the credit cycle, what could be coming forward, and how the market has matured over the decade," said Sean Keenan, vice president and senior analyst at Moody's. "1999 really reflects all of that development of the past ten years."

In the late 1980s, the new issues market was largely dominated by a single player: Drexel accounted for nearly 60% of all new deals, according to Lorraine Spurge of the High Yield Capital Association and a 20-year veteran of Drexel herself.

While secondary market trading included Salomon Brothers, Merrill Lynch and Lehman Brothers, when Michael Milken and company were charged for a number of securities violations and the company dissolved in February 1991, the primary market was shaken by the loss of a major liquidity provider.

And, when the Resolution Trust Corporation ruled that pension funds and savings & loans associations could no longer invest in the junk market, the major buyside players also disappeared.

"The market really shut down for a year or two," said Bob Grossman, group managing director at Fitch IBCA and co-author of December's "High-Yield Industry Default Risk: The Benefits and Limits of Diversification" report. "The lenders couldn't refinance. The predominance of investors were savings & loans and the RTC was saying sell your high yield bonds, so there was nobody to provide high yield money. It was all related to the RTC, and Drexel being the leading market maker - a vicious cycle."

Still, the soaring default rates in the early 1990s had more underlying factors than the collapse of Drexel, said Keenan. In 1991, there were double-digit default rates in nearly half of all industry sectors. An energy crisis that began in the mid-1980s as a reflection of oil price volatility shock sent utilities and energy companies into crisis. And a real estate collapse drove the banking and finance sector into a phase of heavy defaults.

In the seven-year period of strong economic growth from 1992-1998, there were few business failures to scratch the bulk of the high yield market.

Two sectors, however, supermarkets/drugstores and textiles/furniture, hit double-digit default rates over several of these years. The most prominent of these included defaults by Macy's and Hills Department Stores.

Heading into the mid 1990s, with macroeconomic conditions continuing to look favorable, investors began to come back into the high yield market by 1995 and 1996. "By 1996, it was behaving like a mature market," Keenan said.

Investors began holding riskier and riskier credits, moving further and further down the rating scale. Fueled by the well-documented Asian crisis and Russian collapse in August 1998, those credits began to default in 1999.

"There's a huge amount of high yield debt in its second and third year of issuance that's now coming to roost in what I call the aging effect," said Professor Edward Altman of New York University's Stern School of Business and its Salomon Center. "We're now experiencing a regression to the mean in terms of a mortality rate - the rating of an issuer and the number of years since the bond's been issued."

Altman points out that there are pockets of sick industries in the high yield universe. Some, like textiles and retailing, are chronically sick, while some sectors, including healthcare and energy, are going through cyclical downturns.

However, Fitch IBCA warns that the telecom sector may be the next to witness a high default rate.

"More of the new telecom issuance is in more speculative companies," said Mariarosa Verde, director in Fitch's Loan Products Group and co-author of the report.

"The telecom companies of yesterday were stronger quality credits and that was captured in their ratings," she said. "Wireless companies that require a build-out of their network, they won't be cash flow positive for some time."