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News July 15, 2009, 8:21PM EST

The Time Bomb in Corporate Debt

Company defaults on the heels of record borrowing will hamper the recovery. Going straight into bankruptcy may be a healthier option

By David Henry

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No surprise here: As the recession grinds on, more companies are falling behind on their debt payments. The default rate tops 11%, up from 2.4% last year—and could peak at 12.8% by the end of the year, the highest ever, according to credit rating agency Moody's Investors Service (MCO). But what's worrying economists more is that the rate could remain stubbornly high for quite a while. "Be prepared for a multi-year period of high defaults," says Louise Purtle, a senior analyst at CreditSights. "We're going to see peaks like a mountain range."

That's a departure from the usual pattern in recessions, even severe ones. Historically corporate defaults spike as downturns ease, then fall back to more normal levels. But the recovery may be delayed this time around. Companies aren't cleaning up their balance sheets that much, and current debt levels are unsustainable. The debt overhang could hamper the economy for years to come.

The problem, of course, is that corporate borrowers binged on credit during the boom years. Now U.S. companies carry some $1.4 trillion in high-yield bonds and loans, a burden that's nearly triple the amount in 2001, according to Standard & Poor's Leveraged Commentary & Data (MHP), a research group. More than half of the debt comes due in the next five years.

Already the pile of debt is forcing companies to make painful choices that will reverberate through the economy. Consider newspaper publisher Gannett (GCI), which has $3.5 billion in debt and reported $1.1 billion of cash flow in the past 12 months. Amid slipping sales, the company is slashing payroll and cutting its dividend. While Gannett has the money to meet interest payments, it has sharply reduced investments for growth. Says a Gannett spokeswoman: "In the first quarter we paid down debt."

It's proving more difficult to unwind debt today than in previous downturns. Distressed companies can't easily sell assets to pay off debt amid the harsh dealmaking environment. And many owe more than their underlying assets are worth—not unlike homeowners who owe more on their mortgages than their homes would fetch on the market. Meanwhile, big banks and other financial firms, still battered and bruised from the financial crisis, don't have the strength or the will to refinance all that debt.

Without many options, more borrowers will find it tough to meet their financial obligations. So far this year, 128 companies have defaulted, including General Motors, clothier Eddie Bauer (EBHIQ), aerospace company Fairchild, and paper maker Bowater. Those four companies have filed for bankruptcy. S&P figures an additional 207 are "vulnerable" to default. Among the distressed: auto suppliers Accuride (AURD) and American Axle & Manufacturing (AXL), retailers Claire's Stores and Saks (SKS), as well as real estate franchiser Realogy, the owner of the Century 21 and Coldwell Banker brands.

Companies are doing everything they can to avoid default. Some have worked out "amend and extend" deals, which postpone the due dates on their loans. For example, video rental chain Blockbuster (BBI) was able get an extra 13 months to pay off a bank loan. In exchange, the company agreed to pay an additional 8% in interest. Lenders are being cautious. Accuride, which makes chassis for trucks, got a mere 45 days to meet financial tests that are a requirement of its loans. Accuride declined to comment.

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