Bankruptcy Risk Is a Worry Again

The Wall Street Journal

The market's recent losses threaten to awaken the dormant bankruptcy beast.

Yields on risky debt are creeping higher, raising borrowing costs and threatening tougher times for companies that need to refinance billions in obligations.

The gap between rates tied to "junk" bonds issued by risky companies and U.S. Treasurys continued to widen Thursday, to well above seven percentage points, up from more than five at the end of July, according to Bank of America Merrill Lynch's High Yield Master II Index. The spread is even higher for the riskiest debt.

An increasingly harsh economic outlook, flagged by the Federal Reserve this week, leaves these firms facing potential business declines just as investors start demanding more compensation to lend them money or do crucial refinancing deals. The prices of junk bonds, for instance, have been falling just like stocks, pushing their yields, which move opposite to price, higher. For the riskiest firms, investors now command yields on debt well north of 12%.

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Many of these companies have been "kicking the can" over the past two years by extending due dates on debts or raising new money to pay off debts coming due. For the most part, these firms haven't lowered their debt totals and will have to grapple with obligations when they come due again, when credit markets might not be so inviting.

About $949 billion in debt tied to U.S. companies with speculative-grade, or junk, credit ratings comes due through 2015, according to a recent report by Standard & Poor's Global Fixed Income Research. Including weaker companies in Europe and other parts of the world, the debt total is about $1.3 trillion.

If interest rates increase enough, "the bankruptcy filings are going to be higher," said Peter Fitzsimmons, president of North America for AlixPartners, a consulting firm that has advised companies trying to turn around their operations and debt situations.

Even the Fed's move this week to keep its benchmark interest rate low may not save the riskiest companies, whose borrowing costs are mostly pegged to yields on long-term Treasurys that the central bank can't control as easily. Given their myriad challenges, these companies' borrowing costs were already high relative to healthier firms with good credit. The upshot is that companies that investors already deemed risky now are starting to look even riskier.

Tighter credit markets could prove particularly painful for companies whose businesses rise and fall with consumer demand, such as retailers, restaurants, shippers and some manufacturers.

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Real Mex Restaurants Inc., for instance, is among those on a July list of companies with questionable liquidity profiles released by Moody's Investors Service. The Mexican-food chain recently amended debt terms, got more money from its private-equity owner and has to execute a comprehensive restructuring plan by the end of October, according to a regulatory filing. A company spokesman said Real Mex is "in the process of working on a revised corporate capital structure, and all financial stakeholders are at the table."

Moody's also recently raised concerns about Edison Mission Energy's liquidity over the next year. The Santa Ana, Calif., power producer, which carries about $4.6 billion in debt, generates negative cash flow and has suffered delays receiving tax-allocation payments from its parent company, Moody's said. The power company's "fundamental credit profile" could make it hard to extend credit lines that expire in a year, Moody's said in a July report. Yields on some of the company's bonds have risen to nearly 17%, from about 13% earlier this month, according to MarketAxess. A representative for the company declined to comment.

Dynegy Holdings Inc., the big power company owned by investor Carl Icahn and hedge-fund Seneca Capital, suffered a credit downgrade from Moody's in July. Prices have fallen on Dynegy bonds this summer, with yields rising to 17% from 15% in some cases.

Moody's suggested Dynegy would launch a distressed-debt exchange transaction in the next several months. In a possible precursor, Dynegy recently created two subsidiaries as part of an organizational restructuring and borrowed another $1.7 billion. A representative for Dynegy declined to comment.

Bankruptcy filings aren't likely imminent for many struggling firms, restructuring experts say. For now, bankruptcy filings are declining, default rates among weaker companies are low, and credit markets are relatively open. Companies sold a record amount of junk bonds last year and are on pace to sell even more this year.

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And some of the widening gap between rates on risky debt and Treasurys comes amid a recent flight to government bonds that pushed some Treasury yields to record lows.

Many companies that refinanced during the market upswing or earlier got relaxed terms that investors call "covenant-lite." Dynegy's bonds, for instance, have few protections for investors, giving the company freedom to borrow more and pursue other measures.

Still, these and other companies remain on watch lists for Wall Street analysts and restructuring advisers should market conditions worsen for firms considered riskier bets.

"If you kick the can too far down the road, the can kicks back," said Michael Tennenbaum, whose firm Tennenbaum Capital Partners buys distressed debt and makes leveraged loans. He says he has seen an uptick in debt-heavy companies looking to his firm for help.

When making new loans or debt investments, a more-cautious Mr. Tennenbaum now wants stricter terms that prevent companies from borrowing lots of money that would be repaid before the investment firm in the event of a bankruptcy. Tennenbaum also wants other perks that could give the firm ownership stakes in a company when providing debt financing.

Sandwich chain Quiznos tried unsuccessfully to refinance more than $850 million in debt this year before the recent market tumult. Now, Quiznos is on the brink of default after warning lenders it likely violated debt terms. A representative for Quiznos declined to comment.

In a pessimistic scenario, contagion from the stock-market's plunge and European debt problems could cause 62 weaker companies to default over the next year or so, said Diane Vazza, head of S&P's Global Fixed Income Research. Increasing interest rates can "really crush these weak companies," she said.

Marc Lasry, a hedge-fund manager who invests in the debt of troubled firms, recently held off from buying distressed bonds, anticipating their prices would fall further. "You're not really getting paid today for the risk," Mr. Lasry said, suggesting interest rates on riskier debt must rise.

—Joann S. Lublin, Peg Brickley and Prabha Natarajan contributed to the article.

Write to Mike Spector at mike.spector@wsj.com

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