Next Fear: Corporate Debt

Financial markets have been hit by a wave of defaults on mortgage loans. Now it might be time to start worrying about a more-remote threat: shaky corporate debt.

Amid booming profits and extremely low default rates in recent years, many companies borrowed heavily to make acquisitions, go private, buy back stock or pay special dividends in activities designed to boost shareholder returns.

Not long after that binge of borrowing, some cracks are showing in parts of the economy, and the prognosis for corporate balance sheets is looking less rosy.

Fitch Ratings says downgrades of corporate bonds rose in the third quarter to $92.1 billion, their highest level in two years. Meantime, interest rates on junk bonds have risen, potentially straining the ability of low-grade issuers to tap the credit markets for fresh loans or to refinance existing debt. Fitch predicts a jump in corporate defaults, from less than 1% of all debt outstanding in 2007 to more than 4% in 2008. If this happens, it will become harder still for companies to borrow.

Sensing a turn, "distressed investors" -- who seek to gobble up debt when it has hit rock bottom -- have raised more than $300 billion by some estimates to put to work in the years ahead. "We don't need a recession to see an increase in the rate of corporate defaults," says Edward Altman, a bankruptcy expert at New York University's Stern School of Business.

At closely held Buffets Holdings Inc., owner of Old Country Buffet and other chains, potential problems are already surfacing. Buffets borrowed more than $800 million last November to buy Ryan's Restaurant Group, a Greer, S.C., chain.

On Monday, burdened by rising food and labor costs and a heavy interest burden, Buffets posted a $5.3 million loss in its fiscal first quarter, compared with a $1.1 million loss a year ago. Its bonds are now trading at less than half their face value, implying investors see a high probability of default.

A. Keith Wall, the firm's chief financial officer, says Buffets "might break a covenant" in the coming months, referring to performance requirements by debtholders. "We didn't anticipate the cost pressure we're currently seeing," he said. The company also said it has retained a restructuring adviser.

Worries now linger in the corporate-debt markets that some companies have gone too far. Default rates, at 0.4% of total outstanding junk bonds, are at their lowest levels in more than 25 years and a long way from the 16.4% hit in 2002. But they can change fast as the business cycle turns. Between 1998 and 2001, for instance, the default rate on junk bonds jumped to more than 12% from less than 2%.

Brent Williams, a managing director at Chanin Capital Partners LLC, which advises lenders, investors and companies on restructuring situations, says he is "seeing the distressed guys start to circle companies" that have borrowed too much and aren't prepared for an economic slowdown.

Swift Transportation Co., a truckload-carrier operator, has been hit by weak domestic demand for its freight services and high gas prices since it went private in a management-led buyout in May.

The company still generates enough cash to cover its interest costs; however, this cash flow, as measured by earnings before interest, tax, depreciation and amortization, fell 18% from a year ago to a pro forma $110.9 million in the third quarter. That compares with its interest expense of $67.3 million.

Wary of trouble, investors have pushed down the value of Swift's bonds, which are trading at about 63 cents on the dollar, down 37% from the time they were sold in May. Spokesmen at Swift couldn't be reached for comment.

Constar International Inc., which sells plastic containers, is also starting to look troubled, investors say. With about 80% of its sales in the U.S., Constar's earnings have been hit by weaker demand for carbonated drinks. Some of its bonds are trading at 74 cents on the dollar. A Constar spokesman declined to comment.

Many companies have an advantage in this business cycle. In the easy-credit environment of the past few years, many firms were able to secure loans with lax terms that give them flexibility if they run into trouble. "Covenant-lite" loans, for instance, go easy on performance requirements. "Payment in kind," or PIK, terms let borrowers switch interest payments on and off.

Another firm that distressed investors are focused on is Realogy Corp., a real-estate company that owns brokers Century 21 and Coldwell Banker and went private in a leveraged buyout this year. The company has been hit by the housing downturn, and credit analysts see its cash flows shrinking. Its bonds are trading at around 70 cents on the dollar. But because Realogy borrowed using PIK terms, it can stave off interest payment problems for a while.

Write to Karen Richardson at karen.richardson@wsj.com and Serena Ng at serena.ng@wsj.com