The Fires May Not Be Out

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Between 2003 and 2007, lenders financed $194 billion worth of bonds in the bottom tier of non- investment grades, those B- or below. That was twice as much as in the previous four years. The difference is significant. Historically, 23% of bonds in that group default within three years after they are issued, vs. just 3% in the top tier of junk.

Who are some of the borrowers prompting worry? Amusement park operator Six Flags, construction products maker Georgia Gulf (GGC), trucking company Swift Transportation (SWFT), and sports equipment maker Easton-Bell Sports, the debts of which are trading at around 60 cents to 85 cents on the dollar. Six Flags and Swift declined to comment. Georgia Gulf said on May 7 in its first-quarter earnings release that it plans to pay down at least $125 million of debt this year with asset sales, tax refunds, and reductions in capital spending. A spokeswoman says Easton-Bell "has a very strong cash position."

Companies loaded up with debt by their private equity owners are also showing weakness. Half of the 25 defaults since January were products of the leveraged buyout boom. Other deals, including real estate brokerage operator Realogy (H), newspaper company Tribune (TRB), and pizza chain Uno Restaurant Holdings (UNO), are causing concern for creditors, judging by the companies weak ratings. Realogy issued a statement in March criticizing S&P's negative outlook on its grade. Tribune chief Sam Zell said publicly last month that "it does not appear we will have difficulty meeting our commitments." Uno declined to comment.

But if the default trend persists, private equity shops face a slew of losses and costly restructurings at the businesses they own. That could force the LBO firms to try to persuade debt investors to accept new terms, which might include cutting the amount of principal or lowering interest payments. Such negotiations are tricky, though, and would likely prompt more criticism of the buyout industry.

Certainly, some companies will be able to avoid the worst-case scenario—either default or bankruptcy—by offloading assets or parts of their business. Tribune is trying to find a buyer for Newsday, its big Long Island-based newspaper. Dole Food, the junk-rated pineapple and banana giant, is selling land in Hawaii and California. It plans to use proceeds to pay down some of its $2.4 billion in debt, about $350 million of which comes due next year. "This is partly a reflection of tight credit markets and partly normal business activity," says a Dole spokesman.

Others will have to make concessions to lenders in exchange for more time to meet their financial obligations. Faced with a weak advertising market, Spanish broadcaster Univision, which drew down much of its remaining credit line in April, may have to resort to paying its upcoming interest payments with an IOU instead of cash. The move would buy time but increase the company's overall debt. And in the end, Univision may only forestall default rather than prevent it. Univision spokeswoman Stephanie Pillersdorf said the company has "ample liquidity."

Just how much debt will sour in the coming months is a subject of great debate. Rating agency S&P predicts the default rate among U.S. junk-rated borrowers will jump from just under 1% last year to 4.7% over the next year, while other analysts estimate it will soar to as much as 8%. "We're just starting to see the first up-leg in the default cycle," says Diane Vazza, head of S&P's Global Fixed Income Group. Marcia L. Goldstein, head of business restructuring at law firm Weil, Gotshal & Manges, says: "What we're seeing is the effect of looser lending standards."

The hope for relief from the economy is tempered by history. After the last two big lending booms—those for LBOs and commercial real estate in the late 1980s and again for tech and telecom in the late 1990s—default rates soared into the double digits. And should the economy fall into a relatively mild recession like the slump from 1990 to 1991, Martin Fridson, CEO of research service FridsonVision, estimates that defaults could hit 16% for two consecutive years, given how much more debt is on the books of companies this time around. If that happens, it would be the worst carnage since 1933. Says Fridson: "The contraction of credit by the banks has only begun."

Henry is a senior writer at BusinessWeek. Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.