Sharp Rise in Number of Companies With Distressed Debt

The number of companies whose bonds are trading at distressed levels nearly doubled in the last month, to 148, according to Standard & Poor's. Among them are several New York standouts, including Duane Reade, Revlon, and Six Flags.

"These companies are vulnerable and their margins for error are razor slim," a managing director at S&P, Diane Vazza, said.

Because money has been plentiful and cheap over the last several years, many unstable companies have been able to stay afloat by issuing bonds. Many of these bonds, rated as speculative-grade because of their risk, are now trading at distressed levels, or with very high yields. Over the next six months, as the credit market tightens, these companies will be at greater risk of defaulting on the bonds and may be forced to restructure, experts say.

"A shakeout is afoot," the president and CEO of the restructuring firm DSI, William Brandt, said. "Companies that have debt trading at distressed levels are likely to be the companies that have to face hard decisions in the near future, and I believe defaults will double exponentially."

Several New York-based companies are part of this predicament. The makeup giant Revlon, owned by billionaire Ronald Perelman, has not had a positive cash flow in at least five years. It has $167 million in bonds that are maturing next year, and has publicly said it plans to refinance the debt in the coming months.

"They said they plan on refinancing, but they haven't gone into a lot of detail on how they plan to do this," an analyst at S&P, Mark Salierno, said.

"We remain concerned from a credit standpoint given the company I scurrently not generating positive free cash flow while maintaining a high debt burden and highly leveraged capital structure," Mr. Salierno said. S&P has a negative outlook on the bonds.

"As the liquidity markets continue to contract, companies that will need to refinance their debt won't be able to," a managing director at Kroll Zolfo Cooper, Rob Warshauer, said. "I'm starting to hear about a number of companies in this position."

He said he recently met with a firm that has about $1 billion in revenue that had been told by its bankers that it would refinance the company's debt at the end of July. That never happened. "The bankers then told them they could refinance 75% and get 25% of it from elsewhere, but we recently met with the chairman and CEO and they still haven't seen the money," Mr. Warshauer said.

The theme park company Six Flags Inc. could find itself in a similar situation, with $295 million in debt coming due in August 2009. It was lucky in that it managed to take out a $240 million credit revolver in April, immediately before the market began its current cycle of turmoil. "Their timing was ideal," an analyst at Moody's Investors Service, Karen Berckmann, said. "For the next year they are in pretty good shape, but if they don't show any improvements in their operations, they could be in a tough position."

Duane Reade, which last made a profit in 2003, is also in a tough position. It has $405 million in debt and "its liquidity is limited," an analyst at S&P, Diane Shand, said. "Our ratings reflect a belief that the company could default within a year."

Other New York companies with bonds trading at distressed levels include Reader's Digest Association, Sirius Satellite Radio Inc., and Broadview Networks Holdings.

But while more companies have bonds trading at distressed levels, the default rate of 1.2% is at a historic low, and well below the 5% average, according to S&P. But this is a trailing indicator, and it could swing radically higher in the near future.

"I think there is a strong possibility that the default rate will experience a spike over the next six months and this will be problematic because it will further test the market's confidence," a managing director at Fitch Ratings, Mariarosa Verde, said.

Not everyone is convinced, however. "These companies aren't actually going into default at this point," a senior vice president and manager of Callan Associates's private equity research group, Gary Robertson, said. "Widening spreads can be a harbinger of a higher default rate in the future, but for now, this is not the case."

Having said this, Mr. Robertson acknowledges that there are more distressed debt funds — funds that buy up these types of bonds — than ever before. "It is safe to say the smart institutional investors are voting with their dollars, and there are more distressed debt funds now — about $68 billion worth — than ever before in the history of the industry."

Still, it is too early in the credit cycle for these distressed debt funds (known by some as vulture funds) to sweep in and buy up much of this debt. "It is way too early to step in, we want to wait until the market bottoms out before we make our move," a wellknown vulture investor, who requested anonymity, said.