Corporate Debt: The Great Deleveraging

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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.

Watt is a credit analyst for Standard & Poor's Ratings Services.

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