Default With the Economy
Subject Economic Growth
Topic Money and the Financial System
Key Words Defaulted Bonds, Corporate Bonds, Interest Rates, Federal Reserve
News Story

Despite an economic expansion that has lasted longer than any other in the post World-War II era, all is not well in the business sector. Total defaulted debt in the U.S. for the first half of 2000 amounted to $15 billion. At this rate, the year 2000 could break last year's record of $23.5 billion in defaulted debt. With the Federal Reserve attempting to slow economic growth and perhaps push the economy into recession, defaults can increase and intensify the economy's slowdown.

Economists blame bad executive strategies such as ill-conceived acquisitions or bad execution of these strategies, or sometimes both, as part of the reason for the upsurge in defaults. However, these occurrences could not have resulted in defaulted debt without a relaxation in standards in the banking industry that allowed these firms to borrow in the first place. According to Prof. Edward Altman, from 1996 to 1999, "you had a huge number of low-quality issues coming to market." Defaults started increasing within a year or two of the financings.

According to Moody's Investors Service, 6.2 percent of high-yield bonds are now in default. By year-end, Moody's Investors Service predicts the proportion to increase to 7.1 percent and to 8.4 percent by mid-year 2001. Salomon Smith Barney released a report that cited the default rate on bonds as 1.58 percent for the second quarter of 2000, an increase from a 1 percent default rate in the first quarter. The report also said that distressed debt¾debt that had been issued to head off financial problems and possibly bankruptcy¾has yields to maturity that are 10 percentage points above similar Treasury securities. Moody's downgraded the debt of twice as many companies as it upgraded in the first half of 2000, the highest ratio since the last recession in 1991.

As the Fed succeeds in slowing the economy, corporate distress and defaults are likely to rise. Economists, however, do not believe the increase in the default rate will have a significant impact of the economy. The Federal Reserve is concerned and Alan Greenspan, chairman of the Fed, tracks the data on distressed loans and will no doubt take action should this situation change.

(Updated September 1, 2000)


1. What is a bond? What is a corporate bond? Why do firms issue bonds?
2. What determines the price of a bond? What role does risk of default play in influencing the price of a bond?
3. What happens when a firm defaults on its bond payments?

Source Robert D. Hershey, Jr., "In a Humming Economy, A Rising Din of Defaults," The New York Times, August 13, 2000.

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