At the Asian Development Bank meeting in Hawaii last week, Standard and Poor’s, the rating agency, claimed that while 2000 had been the worst year ever for defaults on S&P rated bonds, 2001 was expected to be even worse, with the Asian corporate sector a major component of the problem.
According to S&P, 117 rated companies, with debt of $42.3 billion, defaulted wholly or partially in 2000, making it the worst year in living memory. However, the first quarter of 2001 was even worse, with 48 companies, with debt of $37 billion, defaulting, putting the default rate at more than three times 2000’s level.
In another key statistic, the percentage of bonds issued with speculative (below BBB) ratings compared to all bonds issued rose to a record 38 percent in 2000; this is generally an accurate leading indicator, by about two years, of default rates, which at 2.5 percent of outstanding debt in 2000 were still below the 4.0 percent level reached in 1991. On past form, 2002-03 may thus present a very unattractive picture indeed in the world’s bond markets.
Of even more significance is the steady increase in bond market defaults in the last two decades, with the 1981-82 recession showing a default rate peaking at 1.3 percent, far below that prevailing in 1990-91 or today. Surprisingly, the percentage of speculative grade debt issued in 1980-82 was still 24 percent, only moderately below present levels, so the rise in defaults since that date has been out of proportion to the rise in speculative bond issuance.
Probably the major reason for this, at least in the U.S. domestic market, has been the increasing tendency since 1980 for companies to re-capitalize themselves at the expense of bond investors. Many companies that have issued highly rated debt, have subsequently engaged in stock buybacks, which have weakened their equity base and interest coverage, causing the issued debt to be down-rated and hence to drop in value. This benefits stockholders, and particularly holders of stock options, such as management, at the expense of bondholders, who see their original investment decline in value, sometimes sharply because of management actions over which they have no control. Of course, in the event of an actual default, bondholders have a prior position to stockholders, but by that time it may be too late.
The increasing use of stock options by U.S. companies has, as I have extensively discussed in previous articles, made corporate earnings figures close to meaningless in many cases. It has also, by encouraging re-capitalizations, encouraged management to promise bond investors the security of a company with modest debt and good interest coverage and then, once debt has been issued, turn the bondholder’s investment into a security of an over-leveraged company that is vulnerable to any economic downturn. By reducing the number of shares outstanding, such re-capitalizations then increase earnings per share and thereby benefits management as holders of stock options. This “bait and switch” operation is close to fraud; it is also not something that a well balanced capital market should tolerate.
Standard and Poor’s lectured in Hawaii on the need for Asian companies to undertake better corporate governance, so that bondholders and rating agencies had a better idea what their investment risks were. The ability of companies to re-capitalize themselves, a movement far more prevalent in the United States than in Asia, presents a danger to bondholders that is at least as real as that of inadequate disclosure.
Another possible reason for increasing bond default rates is the increasing internationalization of the ratings process, in particular its extension to emerging markets where political and economic uncertainties are greater. In the 1970’s, only those foreign borrowers wishing to tap the U.S. domestic bond market obtained a debt rating; Eurobond issuers had no need to. Hence, while there were some clear anomalies such as the AAA rating awarded to Venezuela during those years, the universe of rated debt was very largely U.S., or at least North American.
In more recent years the existence of an international high-yield bond market has not only increased defaults directly, it has also enabled sovereign borrowers, such as Argentina and to a lesser extent Turkey, to get themselves into trouble to an extent that would not have been possible two decades ago.
Argentina, in particular, has been rated BB by the major agencies for several years, and yet has been able to borrow not merely international bond debt but international long term bond debt, much of it of 20+ years maturity, at interest rates up to 1000 basis points (10 per cent) above those on equivalent U.S. Treasury bond issues. While the long maturities of bonds issued saved Argentina from repayments crises for a number of years, the high overall cost of the debt also prevented the country from balancing its national budget, and the piper has now to be paid. Argentina’s sovereign debt rating has been downgraded to B, or, on short-term debt, C (implying imminent likelihood of default), and the fiscal stabilization package introduced by the new finance minister Domingo Carvallo has been widely declared to be inadequate, since it does not come close to balancing the country’s budget.
An Argentine default seems inescapable, almost certainly before the end of the year, and since Argentina has $120 billion of foreign obligations outstanding, this will be a very serious matter, both for the country itself and more especially for investor confidence in the international bond markets.
An Argentine default will in turn roil international bond markets, and thereby cause further economic disruption beyond what we have seen already. This will cause the level of corporate bond default in emerging markets, including Asia, to rise to record levels. The result is likely to be a withdrawal of international bond investor support for all but the most highly rated sovereign bonds.
Such a withdrawal would be a close potential parallel to the 1930s, when defaults on Latin American and German debt closed the international bond markets for a decade.
After the cataclysm, the international bond markets will reopen only very gradually, as they did in 1975-6 after the inflationary impact of the energy crisis. At that time, it is likely that investors will look only at bonds emanating from the most highly rated countries such as the United States and Western Europe. If it occurs, this tightening would be a tragedy for the world economy, as emerging markets economic development would be sharply curtailed.
More justifiably, after the crash, investors will demand proper protection from corporate issuers against management looting of their investment in favor of stockholders. Such protection, for example, might take the form of mandatory issuance of stock options to bondholders in the event of a ratings downgrade. Such mandatory issuance would dilute the interests of stockholders in the event of a re-capitalization, thus making it prohibitively expensive. At the same time, unlike the other protective alternative (which has already been tried) of a bond interest rate that rose automatically if the bond rating was cut, such a provision will affect only the economic interest of stockholders, and not the company’s cash flow itself, thus putting the cost of the provision where it properly lies.
Only by such a measure as this will bond market investor confidence be restored. And, historically, worldwide, bonds have quantitatively been a great deal more important than stocks as a source of investment capital.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.