S&P Ratings News

Corporate Debt: The Great Deleveraging


Corporations are deleveraging their balance sheets—whether by choice or because of circumstances. A number of obvious factors are behind this, one being investor sentiment in the capital markets. The capital markets are generally more receptive and have a more favorable view of issuers with solid credit profiles and sufficient liquidity to withstand and persevere through the economic downturn. For example, investment-grade (BBB- or above) bond issuance is robust because investors have more confidence about the ability of companies with stronger credit profiles to maintain acceptable credit quality in this recession.

While the debt markets have been accommodating to investment-grade issuers, they've largely turned away speculative-grade issuers. Many speculative-grade companies became overly burdened with debt when credit terms were abnormally lax and the cost of debt was extraordinarily low. In many cases, some form of financial restructuring has been necessary because of overleveraged capital structures arising from the cheap credit available in 2005-07.

For lower-rated speculative-grade issuers, the recessionary operating environment has intensified their troubles. So business plans premised on supportive economic conditions have been undermined by the combination of high debt leverage and deteriorating financial performance. More specifically, we currently rate about 200 U.S. entities in the CCC category or below, ratings that indicate a high degree of financial distress. An additional 200 or so nonfinancial U.S. companies have corporate credit ratings of B- and are therefore in a vulnerable credit situation. Such companies are now exercising financial discipline because the credit markets are reluctant to fund entities with such low credit profiles.

Massive Bankruptcies A clear, and perhaps perverse, instance of this great unwinding of corporate leverage is the surge in bankruptcies. Through the first half of this year, 117 nonfinancial U.S. companies defaulted on more than $339 billion of debt, including companies involved in a distressed exchange or buyback of debt, as well as other selective defaults, according to Standard & Poor's Global Fixed Income Research. The staggering amount of defaulted debt in just the first half of 2009 is triple the defaulted debt for the whole of 2008. Massive bankruptcies such as General Motors and Chrysler (not rated) have been the primary causes of the surge in defaulted debt. In addition, the outright failure of other large companies, such as Nortel Networks (not rated), that were well regarded not so long ago is a contributing factor.

Moreover, financial restructuring actions that S&P considers selective defaults rose dramatically in the first half of 2009, to 36 in the U.S. from just 12 in 2008, as companies sought to repair their financial profiles through distressed debt repurchases. For example, we lowered ratings on Las Vegas-based Harrah's Entertainment (CCC+) and its wholly owned subsidiary, Harrah's Operating Co. (CCC+), to SD (selective default) from CC following the settlement of the company's below-par debt tender offer in April 2009. We view these debt exchanges as being tantamount to default given the distressed financial condition of the company. These management actions to restructure Harrah's debt obligations were meant to ultimately reduce its debt leverage.

Other common factors fueling the deleveraging include:

• Lenders are providing less credit under more onerous terms, thereby forcing deleveraging;

• Mergers and acquisitions are now funded in a more balanced manner and not as reliant on a large portion of debt financings; and

• The dismal economic outlook has muted financial performance of rated issuers and placed more attention on the sustainability of the company's financial position.

Lenders Shy Away from Riskier Issuers Lenders' reluctance to provide financing to entities with marginal or weaker credit profiles manifests itself when companies violate covenants and struggle to refinance the full portion of their outstanding debt with their lenders. Broadly speaking, the weakened financial condition of banks and greater risk aversion of lenders in general have resulted in lenders' increasing reticence to extend credit to lower-rated speculative-grade issuers. In our opinion, it appears that lenders are trying to extricate themselves from weaker or deteriorating credit situations. Also, there are fewer lenders because of the consolidation of banks such as Wells Fargo (WFC) and Wachovia, and of JPMorgan (JPM) and Washington Mutual.

Moreover, outright bank failures, or lenders that are in precarious financial condition like CIT, limit the debt financing options for borrowers. In addition, lenders have tightened lending standards and exacted higher interest rates and fees, thereby putting more pressure on borrowers' finances. This is especially problematic for borrowers with excessive debt burdens and dismal economic prospects. Therefore, management teams have to implement some form of deleveraging to ensure their companies' viability.

The Market for Some Structured Finance Products Has Dried Up The severe contraction in the issuance and availability of financing for structured products also compounds the financing shortfall. For example, in some segments of the market, like collateralized debt obligations, issuance has declined by more than 80% in 2009 from 2008, according to S&P's Leveraged Commentary & Data. Lower-rated speculative-grade corporate issuers, in particular, had tapped this market for some measure of funding through vehicles such as collateralized debt obligations and collateralized loan obligations. This financing avenue is largely closed, which disproportionately affects lower-rated issuers with weak and deteriorating credit profiles because they had relied heavily on this method of funding.

The prospects for the revival of these types of structured products for funding low-speculative-grade rated companies look dim over the next couple of years. Ultimately, this spurs further deleveraging of corporate balance sheets, through management or sponsor actions, financial restructuring, or bankruptcies.

Consumers Have Yet to Bounce Back Economic prospects also influence financial deleveraging. A rising unemployment rate, which appears poised to pierce the 10% threshold, and generally weak economic conditions are thwarting hopes for a consumer-led recovery. In fact, an overleveraged consumer and weak consumer confidence undermine the likelihood of a solid economic recovery.

The economy is critical for any development on the deleveraging front, both in terms of investor sentiment and prospects for improved operating performance of issuers. At this point, it is unlikely that an economic rebound will occur soon enough or be strong enough to alleviate the need for considerable deleveraging across U.S. corporate issuers.

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