7 December 2022 Corporate default and corporate stress

Corporate default and corporate stress​

What do you need to know this week?

Evidence of an ongoing recession in the UK and abroad continues to mount: retail consumer spending in Europe has slowed by nearly 2%. The Confederation of British Industry — the UK’s largest business group — predicts that the UK will be in recession for the entirety of 2023. Though the most recent data suggests that the inflation rate has peaked for many countries, it is unlikely to return to “normal” levels any time soon. In short, as has been the refrain for some time, cheery economic times these are not.

That said, aside from certain high-profile collapses like online retailer Made.com and crypto-currency platform FTX, the number of corporate defaults remains surprisingly low.

However, the actual rate of corporate distress is high, which portends a wave of defaults in the future. And indeed, corporate credit rating agency S&P announced last week that it expects the rate of speculative-grade corporate defaults to increase by as much as three times their 2022 rates beginning in 2023.

Why is this important for your interviews?

There is a subtle distinction between corporate distress and corporate default, which if you can articulate will impress interviewers — especially if you are interested in debt capital markets, restructuring, and banking/finance law.

Corporate default

A corporate default is a definitive event where, as the term suggests, a company defaults on the terms of its loan. The most serious default is the non-payment of money when it is due. However, the terms that govern loans and bonds also create other obligations that, if breached, constitute an effective default. The most common form is where a company breaches a financial covenant, such as a term in a loan that requires a company not to exceed a specified cash to debt ratio (“liquidity covenant”).

The latter kind of default almost always precedes the former because the legal terms that govern most debt are designed to alert to lenders to the risk of non-payment before non-payment actually happens. In practice, where a covenant breach is anticipated, borrowers notify their lenders and/or bondholders in advance. Provided the company can reassure their creditors that they can continue to service their debt, the creditors will waive the breach and a default is averted. The company then works towards a more permanent solution, such as a restructuring.

The issue is where a company cannot obtain a waiver. This usually indicates that the lenders are concerned that the company will not be able to pay off its debt in the near future. In such a case, the most likely outcome is a more aggressive restructuring that may see shareholders’ stakes wiped out. In more dire cases, the company may enter a formal insolvency process (see this week’s articles on Joules Limited).

Corporate distress

Corporate distress is a nebulous term that refers to companies exhibiting certain features that suggests they may ultimately default. There are various ways to measure corporate distress with reference to a company’s accounts, and financial analysts as a species are pretty good at spotting it well in advance.

One strong indicator that analysts have doubts about a company’s performance is if the company’s publicly traded debt (i.e. bonds traded on the secondary market) is trading at more than 1,000 basis (10%) points above risk-free government bonds.

To understand why this is significant consider the following simplified scenario:




While B’s risk of not being repaid when the bond matures is quite high relative to other investment opportunities (such as government bonds), if BadCo is repaid, the return on B’s initial investment is 20%, which is significantly higher than what BadCo would get if it bought UK gilts (i.e., more than 1,000 bps [10%] higher).

As such, investors consider BadCo’s bonds to be distressed.

How is this topic relevant to law firms?

Practice groups in high yield debt and restructuring teams follow companies in corporate distress closely because it is more likely they will default.

Weil Gotshal & Manges, widely considered to have one of the world’s best restructuring practices, periodically publishes its “European Distress Index”. The index measures current deterioration in financial market conditions (by sector), which is a proxy measure for future default rates.