News July 15, 2009, 8:21PM EST

The Time Bomb in Corporate Debt

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"Band-Aid" Relief

Other companies have stays of execution built into their bonds already. During the boom years, more than 60 companies issued bonds that allowed them to put off interest payments for the life of the bond. In a sign of distress, at least 23 companies are using that option today, including casino giant Harrah's Entertainment, chipmaker Freescale Semiconductor, and retailer Neiman Marcus. Neiman Marcus declined to comment. Harrah's and Freescale didn't return calls.

But such moves provide only temporary relief. The arrangements "are like Band-Aids," says M. Christopher Garman, editor and publisher of Leverage World. They "don't solve the basic problem" of too much debt. Instead, companies are postponing the inevitable, which weighs down their balance sheets and drags down the broader economy.

Look at the recent spate of debt modifications. In the first six months of 2009, nearly 40 companies made special deals with creditors to trim their debt. Generally, only a handful of companies make such arrangements each year. And they're often unsuccessful, according to a recent study by Edward I. Altman, a professor at New York University's Stern School of Business: About half the companies that got these sorts of concessions end up filing for Chapter 11 anyway. "It's a disturbing statistic, because it implies either that their problems were more than debt or that the reduction in debt wasn't enough," says Altman.

Chapter 22

The trend persists today. In May 2008 amusement park operator Six Flags (SIXFQ) persuaded a group of creditors to reduce its debt by 5%, or $130 million. The move gave Six Flags some breathing room for its busy summer season and a chance to improve its fortunes. But the company's problems proved insurmountable. Six Flags filed for bankruptcy in June 2009.

Media conglomerate Charter Communications filed for bankruptcy in April after lenders modified its debt several times. "Most of the widely used out-of-court restructuring options, such as debt exchanges or refinancing, do not solve the ultimate problem" of excessive leverage, says Bradley Rogoff, a bond strategist at Barclays Capital (BCS). Six Flags declined to comment.

The economy may be better off if companies filed for bankruptcy at the outset. Sure, Chapter 11 isn't a cure-all. Many companies that get out of bankruptcy return to court in what experts sarcastically refer to as Chapter 22.

But the proceedings do a better job of cleaning up the books and reducing debt loads. Spectrum Brands, the maker of Rayovac batteries, Tetra fish food, and other consumer products, is set to emerge from bankruptcy in August with one-third less debt than when it filed in February. That's twice the relief that companies typically get from creditors out of court. Bankruptcy "often yields better results than just tinkering with the debt and keeping the same management," says Garman of Leverage World. "The only way to really repair a balance sheet thoroughly is Chapter 11." And the more debt that's wrung out of the system, the stronger the overall recovery.

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Default Despair

While much of the corporate sector is suffering, the pain varies greatly by industry, according to a July report from credit rating agency Standard & Poor's (MHP) (which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP)). Homebuilders and media companies, whose default rates top 10%, are in the worst shape. Surprisingly, financials are among the strongest, with a rate of 2.17%. Only two industries have default rates below their historical averages: telecommunications and utilities.

To read the full report go to http://bx.businessweek.com/us-economy/reference/

With Ben Levisohn in New York. Henry is a senior writer at BusinessWeek.