It was precisely a year ago in this column that we looked back and reflected on the cooling market for debt defaults, restructurings and corporate bankruptcies in 2003. Given the breakneck pace of debt defaults in 2001 and 2002, particularly those resulting from the telecom bust and a few exceptionally large corporate bankruptcy filings, nobody realistically expected a repeat performance in 2003 or anytime soon. Sure enough, defaults and bankruptcies moderated significantly in 2003 to levels that at one time would have been considered a banner year but still managed to disappoint those who were spoiled by the preceding two years of hyperkinetic activity. Moody's speculative-grade corporate default rate in 2003 was near its long-term (1981-2004) historical average rate of approximately 5.0 percent.

A paramount question on the minds of restructuring professionals a year ago was whether corporate default and bankruptcy rates would plateau somewhere near the robust (but unspectacular) levels of 2003 or moderate even further in 2004. At the time, projected default rates for 2004 suggested that bankruptcy activity could return to an environment that resembled 1999—nothing stellar, but a pretty busy year for the profession by our recollection (if only!). In retrospect, 2004 was another year of strong earnings growth and expansion for American business and one of risk-taking and yield-chasing in the capital markets—much like 1997-98, but on an even grander scale. It was a remarkably bullish year for the loan and bond markets in particular, surpassing frothy and bordering on giddy. Any somber predictions of an economic slowdown caused by rising interest rates, energy prices, budget imbalances or a host of other worrisome signs went unheeded and unfulfilled.

Thriving Borrowers

So what happened? For starters, corporate debt default rates plunged below their long-term average and touched lows not seen in seven years. Standard & Poor's (S&P) reported only 49 events of default in 2004 affecting $16.2 billion of debt, down nearly 60 percent in number and 75 percent in dollar volume compared to 2003 (see Chart 1). U.S. companies accounted for 40 of these defaults and $13 billion of this debt, respectively. Moody's default totals for 2004 were virtually the same. Consequently, S&P's global speculative-grade default rate fell to 1.8 percent in 2004 (2.3 percent in the United States), well below the 3.5-4.0 percent default rate initially forecast by the rating agencies in early-2004 (see Chart 2). Only five defaults topped $1.0 billion. Across the pond, European companies accounted for but three events of default in 2004.

As for public company bankruptcy filings, they fell to 84 in 2004, down 40 percent from 2003 and way down from the record high of 257 in 2001, according to BankruptcyData.com.

Furthermore, credit quality, as measured by relative S&P credit rating upgrades to downgrades, also improved significantly in 2004, with the downgrade/upgrade ratio breaking below parity (i.e., more upgrades than downgrades) for the first time since 1997 (see Chart 3) and easily besting its long-term average of 1.7.

These propitious developments did not go unnoticed by fixed-income investors, who absorbed more low-rated speculative-grade bond issuances than they had in many years and accepted narrowing yield spreads for this risk as well. Issuances of high-yield bonds soared past the $100 billion mark once again in 2004.

S&P reported that of 728 total new issuers in 2004—the largest number since 1998—62 percent were rated speculative-grade right out of the box, the largest percentage rated junk since 1998 (see Chart 4). Of greater concern, the proportion of new speculative-grade issuers that were considered "deep junk"—that is, rated single-B or worse—increased sharply in 2004 to 69 percent, the highest level in the last 15 years (see Chart 5.

If this warm reception for risky credits wasn't friendly enough, yield spreads on speculative-grade bonds continued to narrow in 2004 following a monster year of yield contraction in 2003 (see Chart 6). By year-end 2004, an investor would have had to venture into CCC territory in order to get a double-digit yield-to-maturity. Consensus opinion a year ago that all long-term interest rates would rise in 2004 in concert with Fed tightening and that speculative-grade yield spreads couldn't possibly narrow further following their strong showing in 2003 was wrong on both counts. Those tempted to conclude that we have reached a cyclical low in high-yield spreads ("How could we not have?," any reasonable person would ask.) should recall how many pundits were saying the same thing a year ago.

Liberal Lenders

Traditional bank lenders got back to the business of lending in 2004, and in a big way. After contracting by nearly 18 percent between mid-2000 and the end of 2003, outstanding commercial and industrial (C&I) loans on the books of FDIC-insured banks jumped nearly 9.5 percent through September 2004.

The most recent Federal Reserve Senior Loan Officer Opinion Survey (January 2005) only lends further support to the strength of the lending markets. The percentage of respondents reporting stronger demand for C&I loans reached a level not seen in years, with nearly 50 percent of respondents reporting stronger loan demand from large borrowers (sales greater than $50M) than just three months ago. Meanwhile the percentage of respondents tightening lending standards or increasing spreads on loan rates reached lows not seen since 1993-94.

As for loans to non-investment grade borrowers—well, let's just say that everyone was invited to this party. Loan Pricing Corp. (LPC) reported that leveraged lending hit $480 billion in 2004 compared to $330 billion in 2003, a 45 percent increase—of which $208 billion was new money (i.e., non-refinancing). But the real driving force behind this brave new world of lending wasn't banks, it was institutional investors. LPC reported an additional $223 billion of institutional loan issuance in 2004, up nearly 90 percent from a year earlier—of which $106 billion was new money! Institutional investors are simply awash in liquidity, and much of it has found its way into the coffers of riskier borrowers. Chart 7 attests to the growing muscle of institutional money in U.S. credit markets.

LPC also noted the following factoids that would be of particular interest to restructuring professionals:

• Loans to finance LBO transactions surpassed $50 billion in 2004, the biggest year since the late eighties. Dividend recapitalizations by LBO sponsors were also quite popular in 2004.
• Middle-market loan issuance (for all purposes) to equity sponsors hit $52 billion in 2004 compared to $27 billion in 2003.
• M&A-related loan issuance more than doubled in 2004 to $160 billion from $72 billion in 2003.
• Syndicated asset-based loans hit $51 billion in 2004 on 352 deals compared to $41 billion and $24 billion in the two preceding years. The vast majority of deals were in the $50-$150 million range. Asset-based loans have shed their stigma as the structure of necessity for distressed borrowers and have become the loan structure of choice for many non-distressed borrowers who see it as a cheaper, less onerous alternative to cash-flow loans.
• Second-lien loans, a popular topic of discussion these days, hit $20 billion in 2004. These hybrids have become a cheaper, more attractive alternative to traditional mezzanine financing for borrowers needing bridge financing. LPC reported that second-lien loans to middle-market borrowers were about 700 basis points over LIBOR in 4Q04, only about 300 basis points more than first-lien loans to these smaller borrowers. It should be noted that many standard features of these novel loan structures have yet to be tested in a bankruptcy setting.

Conclusion: Caveat Lender

"Why all these statistics?" you may wonder. We're fairly certain that most readers of this column have a general sense of the euphoric state of the credit markets these days, but we think the hard numbers really reinforce just how heady things have gotten. Many restructuring professionals now believe the next bust cycle won't kick in until 2006. Both rating agencies expect the speculative-grade default rate to bottom out in mid-2005 and begin a gradual ascent that will carry it slightly higher by year-end. Moody's is looking for a 2.7 percent default rate by the end of 2005—still well below its long-term average. Even USA Today had a recent article, "Chapter 11 Bankruptcies on the Verge of Surge?"—proof that this sentiment may have reached the point of consensus opinion. Recall that it took some three years from the peak of the last credit expansion cycle in 1997-98 until the bust really hit with full force in 2001. The truth is, we just don't know when the next bankruptcy cycle will begin and we don't care to hazard a guess, but doubtless the seeds have already been planted. What we do feel pretty strongly about is that when the cycle does begin, it will be distinctly different from 2001-02 in several critical respects.

• In contrast to the mega-bankruptcies of 2001-02, the next default cycle will be littered with smaller middle-market busts, particularly broken LBOs and other sponsored-backed deals.
• The surge in asset-based lending, especially if it continues, will prompt secured lenders to get actively involved in troubled credits sooner and move more quickly to protect collateral values, even if that means precipitating a reorganization, in or out of court.
• Arranging for DIP financing will be a daunting challenge for debtors whose assets are already highly encumbered going into bankruptcy. Quick sales of businesses and assets are more likely to ensue.
• Holders of second-lien loans will likely see lower recoveries in default than they had anticipated going into these deals.
• Getting restructuring professionals involved in a deteriorating situation earlier—when there is a wider range of restructuring options—will, more than ever, be critical to successful turnarounds.

It was the philosopher George Santayana who gave us that renowned quotation that those who cannot remember the past are condemned to repeat it. These are truly words to live by, unless you really need to put money to work.