The Impact of Economic Recovery on Large Business Failures
Even with the benefit of hindsight, it's not easy to characterize the year of 2003 for the turnaround and restructuring advisory profession. Undoubtedly, it was a transitional year. "A transition to what?" you might ask. At first glance, one might be tempted to conclude it was the year the party finally began to wind down for restructuring professionals. A U.S. economic recovery began in earnest in the second-half of the year—certainly, an earnings recovery did—some 19 months after the official end of the 2001 recession. Standard & Poor's (S&P) estimates that operating earnings for the S&P 500 improved by 18.5 percent in 2003 over 2002—an impressive feat indeed, considering how limited top-line growth was during this early recovery period.
Following the same script, corporate debt defaults fell dramatically in 2003. S&P reported (Chart 1) that worldwide corporate debt defaults in 2003 fell 67 percent in dollar volume to $62 billion, and 46 percent in number to 126, compared to 2002. The relative absence of behemoth-sized failures in 2003 caused dollar-volume measures of default to decrease at a far greater rate than defaults by issuer count. U.S. companies accounted for 75 percent of these defaults in number and 67 percent in dollar volume—about $40 billion in 2003. By year's end, the 12-month rolling speculative-grade corporate default rate had fallen to 4.7 percent (Chart 2), finally breaking below its long-term average of 5.17 percent for the first time in nearly five years, according to S&P.
All this came as welcome news for securities markets. Speculative-grade bond yields fell sharply across the entire junk ratings spectrum in 2003, with the most pronounced drop in yields occurring for many deep-junk issues. We're not just talking about junk bond yields falling commensurately with the lower interest rate environment: High-yield spreads over comparable treasuries contracted severely in 2003. The yield curve for non-investment grade issues flattened as intrepid investors' reach for yield became voracious. Spreads for BB-rated issues fell 230 basis points in 2003 and B-rated issue spreads fell approximately 400 basis points, while CCC-rated issues saw yield spreads fall about 1,000 basis points (Chart 3).
As for issuances of high-yield debt, 2003 was a bonanza year with $122 billion of new junk issued, according to the Bond Market Association—double the amount of 2002, and the second-best year on record after 1998. It was also the first time since 1998 that the $100 billion threshold was crossed. However, unlike the junk bond apex of 1997-98, a greater percentage of these proceeds were earmarked for debt refinancing. Moody's estimates that nearly three-quarters of new issuance proceeds in 2003 went to refinance outstanding bonds and bank loans. Maturities were lengthened as well, with only 19 percent of these new high-yield issues coming due in less than seven years, according to S&P.
The rally in the junk bond market is expected to continue in 2004. The Bond Market Association forecasts a new high-yield issuance of $125 billion this year, up 2.5 percent over 2003, in contrast to an expected issuance decrease of almost 40 percent (yes, 40 percent) for new investment-grade debt. Despite the steep run-up in junk bond prices last year, a sustained U.S. economic recovery in 2004 is expected to keep credit-quality concerns at bay and embolden yield-hungry investors. Historically, high-yield issuances of this magnitude over a multi-year period would set the stage for the next default cycle three to four years hence—the so-called "aging effect" by Moody's. However, if issuance proceeds continue to emphasize refinancing over investment or acquisitions, even this phenomenon may not strictly conform to past norms.
To nobody's surprise, preliminary figures from BankruptcyData.com showed a decline in the number of large corporate bankruptcies in 2003, especially in the $500+ million categories, as seen in Chart 4. Significantly, the number of billion dollar bankruptcies was less than half that of 2001. When the final bankruptcy data is in for 2003, we'll undoubtedly see that the percentage decline in bankruptcy assets will far exceed the decline in case count, as was the case with debt defaults. The sharp decline in mega-sized failures in 2003 accounts for this disparity.
These developments would appear to augur poorly for those whose livelihoods depend on corporate distress and bankruptcy. However, a balanced assessment of the year reveals that business failures were still plentiful in 2003, and the falloff from the unsustainable pace of 2001-02 shouldn't hastily be characterized as a slump. The truth is that we all became just a bit spoiled by the windfall of past few years. In the process, the years 2001-02, understandably but unfairly, became a measuring stick for many professionals rather than a serendipitous anomaly (even for a cyclical extreme point) that may not repeat itself anytime soon. Any restructuring practice that geared itself up for that level of activity going forward was bound to be disappointed by 2003. But were it not for those two extraordinary boom years for defaults and bankruptcies, 2003 would have been considered a bounteous year for the profession by any reasonable standard—certainly by any pre-2001 comparison. Instead, we heard frequent grumblings that the "good old days" were over. Perhaps so, but that really depends on the reference point one selects when making comparisons or forming expectations. However it is that we choose to measure corporate distress, be it default rates or bankruptcy filings or credit rating downgrades, recent data points approximate those of the very late-nineties, and we don't seem to recall much grumbling back then about business being soft.
Looking ahead, the ongoing economic recovery doesn't preclude 2004 from being a moderately prosperous year for the restructuring profession as a whole. Notwithstanding the default wave that has already passed, the prodigious growth of the high-yield market since 1996 and the continued willingness of investors to take on greater credit risk all but assure that corporate debt defaults will never return to the modest levels of the mid-nineties or earlier even as default rates continue to fall. Moody's estimated that the size of the U.S. speculative-grade market was approaching $700 billion at the end of 2003, of which two-thirds was rated B1 or lower. By this figure, speculative-grade debt now constitutes close to 20 percent of some $3.6 trillion of U.S. corporate debt outstanding. Globally, capital flows have made speculative-grade debt an investment fixture in other regions, particularly the original EU nations and Eastern Europe. We're probably talking about a market that will soon be approaching $1 trillion globally. To appreciate this rapid growth, consider that back in 1991, when the global corporate speculative-grade default rate hit a post-World War high of 11 percent, only $23 billion of issues defaulted. Today, if the global speculative-grade default rate were to drop to 4.2 percent this year, one full percentage point below its long-term average, it would still translate into $37 billion of corporate debt defaults annually—putting us right back in 1999-2000 territory.
As for U.S. public company bankruptcies, we took a stab at estimating this number for 2004 by correlating it with the U.S. speculative-grade default rate over the last 22 years (Chart 5). The fit of this relationship was better at lower corporate default rates, where we are right now. The regression model projects 120 public-company bankruptcies in 2004 given the rating agencies' corporate speculative-grade default rate forecast, compared to 195 in 2002. Once again, this puts us back to levels of the late-nineties. Assuming that the average asset size of a public company bankruptcy decreases to $500 million (from a skewed average of $1.5 billion in 2001-02), this represents some $60 billion of assets at bankrupt public companies—pretty much where we were in 1999. If one were to establish a baseline from which to measure the robustness of corporate distress activity going forward, the year 1999 would appear to be the proximate touchstone.
Finally, poor corporate credit quality remains very much an issue still with us. The proclaimed improvement in credit quality last year was rather misleading; it only meant that credit downgrades stopped accelerating, but issuers receiving downgrades in 2003 still outnumbered issuer upgrades by a margin of approximately 2.5 to 1.0, according to Moody's Investors Service and S&P, compared to a cyclical low of more than 4.0 to 1.0 in 2002. At a comparable point in time in the previous economic cycle—around 1993—the downgrade/ upgrade ratio was very close to parity (Chart 6). From a credit-quality perspective, much of corporate America is more vulnerable today as it begins this phase of cyclical expansion than it was last time around. Don't put away your party hats just yet.