Warning signs are popping up around the investing world. They point to weakening demand for non-investment-grade, or “junk,” bonds. Weakening demand for these bonds leads to rising corporate bond yields -- an Achilles’ heel for the private equity-led stock market rally. Hundreds of billions of dollars worth of loans and corporate bonds must be issued in the coming months to finance the big “going private” transactions announced in recent months.
Institutional investors -- those who manage huge fixed-income portfolios -- often reach too far for an extra percentage point in yield. Those with long memories hesitate to buy riskier securities in exchange for just a little extra yield, but novices have clearly thrown caution to the wind and bought anything with a spread over U.S. Treasuries. These investors, especially foreign institutional investors, have been ignoring default risk at their own peril.
As the collapse of New Century Financial unfolded in February, those who had been aggressively buying mortgage-backed securities (MBS) discovered that subprime mortgage debt was not as rock solid as they had previously thought. They were burned by any MBS that held subprime paper; as a result, the flow of credit into this space has slowed to a trickle. The subprime foundation of the “move-up” housing phenomenon began shaking in February.
These once-burned bond investors are now apparently rethinking their strategies for investing in junk bonds -- even the notoriously yield-hungry Japanese and Europeans seem to be less enthusiastic about supplying credit to the riskiest deals.
The latest issue of The Economist features a great piece on the waning enthusiasm to fund private equity, or LBO, transactions. According to the author:
“Investors still holding American subprime mortgage debt might not be the only ones feeling a little queasy. In Asia, a sizeable bond sale from MISC, the world’s largest owner of liquefied natural gas tankers, has been postponed. In Europe, ArcelorMittal, the world’s largest steelmaker, put back a bond sale too. U.S. Foodservice, an American wholesaler, has made such hesitance look like a trend by delaying plans to raise $2 billion in loans. That spells trouble for even bigger issues on the horizon, like the $62 billion that Cerberus Capital Management, an investment firm, hopes to raise for Chrysler, which it is buying.”
The sheer size and the terms of these deals are starting to overwhelm most buyers of corporate debt. The Cerberus-led buyout of Chrysler is a deal that’s particularly fraught with risks; unions, gasoline prices, fickle car-buying preferences, and capital-intensive operations are but a few of the risks involved with owning one of the “Big Three” auto companies.
But Cerberus expects that control of a privately owned Chrysler will allow it so much operational flexibility that it’s willing to pile leverage onto the automaker’s balance sheet in order to achieve the returns it seeks. If it makes this work, Cerberus stands to make a killing; in its view, the potential returns are worth the risk.
I doubt this is the case for those providing the $62 billion worth of credit to fund the deal. They’ll be receiving bond-like returns while taking equity-like risk. If the deal doesn’t work out, they could end up losing a huge chunk of their principal.
I’m confident that Cerberus will structure the deal so that it protects its interests first under all scenarios -- this may include the immediate payment of a dividend to itself or structuring the bond offering as one of the “covenant-lite” variety.
Covenants are restrictions and benchmarks that creditors impose on corporate borrowers to protect their claims on company assets, rather than allow their claims to be diluted by shareholder actions (in the case of Chrysler, Cerberus is the leading shareholder and those buying the $62 billion worth of bonds are the creditors).
Demand for “covenant-lite” loans reached a crescendo in the first half of 2007, but now appears to be waning. The Economist article describes this development:
“The place to look for a decisive shift in sentiment [toward junk bonds] is in the buyout market, which has been fueled by a trio of habits that in more sober times would have had lenders reaching for the Alka-Seltzer.
“The first of these lies in the burgeoning market for ‘covenant-lite’ loans. Loans normally require borrowers to maintain financial thresholds, like limiting debt to 5 times cash flow. But a huge number are now lacking such ‘maintenance covenants,’ which means that banks have less grip on borrowers when business turns sour. The total amount of covenant-lite loans issued in the first two quarters of 2007 has been $105 billion, which tops the $32 billion of all such loans written from 1997-2006 [emphasis added], according to Standard & Poor’s, a rating agency.
“The largest issuers of the covenant-lite loans are private-equity firms, which have been able to dictate terms to lenders. Kohlberg Kravis Roberts (KKR), a big buyout firm, filed to raise a record $16 billion of such loans last month to finance its buyout of First Data. Covenant-lite loans now account for almost 35% of all loan issuance in America.”
Covenants can require the borrower to maintain a cap on debt-to-cash flow ratios (aka “leverage”), or forbid the borrower to make dividend payments or repurchase stock. Creditors don’t like to see big dividend payments extracted out of the company that owes them money; every dollar that’s paid out as a dividend is a dollar that can’t be used to pay them back.
But loose or nonexistent covenants are not the only evidence that creditors have been ignoring their own interests. “Some firms bought by private equity have been issuing payment-in-kind (PIK) notes. These allow them to pay interest in the form of further loan notes, rather than hard cash.”
This is little different than a household making mortgage payments with a credit card rather than a checking account.
It’s hard to imagine a more egregious malpractice on the part of the creditor. Yet up until recently, creditors have been accepting PIKs in lieu of interest payments without fully recognizing that PIK notes are basically a sign of corporate distress.
The bottom line in this whole situation is that the claims on corporate America’s assets and cash flows have been sliced up and divvied out among all sorts of exotic securities at an unprecedented pace. This situation -- where the ultimate lender is five or 10 intermediaries away from the ultimate borrower -- usually doesn’t end well. Somebody along the lending chain is going to get blindsided by losses on junk bonds. The original underwriter of loans is motivated by the quantity of deals he can underwrite, not the quality. They write loans, get them off their books, and start the process all over again.
By late summer, we may reach a point at which supply of risky corporate bonds temporarily overwhelms demand.
Institutional investors -- those who manage huge fixed-income portfolios -- often reach too far for an extra percentage point in yield. Those with long memories hesitate to buy riskier securities in exchange for just a little extra yield, but novices have clearly thrown caution to the wind and bought anything with a spread over U.S. Treasuries. These investors, especially foreign institutional investors, have been ignoring default risk at their own peril.
As the collapse of New Century Financial unfolded in February, those who had been aggressively buying mortgage-backed securities (MBS) discovered that subprime mortgage debt was not as rock solid as they had previously thought. They were burned by any MBS that held subprime paper; as a result, the flow of credit into this space has slowed to a trickle. The subprime foundation of the “move-up” housing phenomenon began shaking in February.
These once-burned bond investors are now apparently rethinking their strategies for investing in junk bonds -- even the notoriously yield-hungry Japanese and Europeans seem to be less enthusiastic about supplying credit to the riskiest deals.
The latest issue of The Economist features a great piece on the waning enthusiasm to fund private equity, or LBO, transactions. According to the author:
“Investors still holding American subprime mortgage debt might not be the only ones feeling a little queasy. In Asia, a sizeable bond sale from MISC, the world’s largest owner of liquefied natural gas tankers, has been postponed. In Europe, ArcelorMittal, the world’s largest steelmaker, put back a bond sale too. U.S. Foodservice, an American wholesaler, has made such hesitance look like a trend by delaying plans to raise $2 billion in loans. That spells trouble for even bigger issues on the horizon, like the $62 billion that Cerberus Capital Management, an investment firm, hopes to raise for Chrysler, which it is buying.”
The sheer size and the terms of these deals are starting to overwhelm most buyers of corporate debt. The Cerberus-led buyout of Chrysler is a deal that’s particularly fraught with risks; unions, gasoline prices, fickle car-buying preferences, and capital-intensive operations are but a few of the risks involved with owning one of the “Big Three” auto companies.
But Cerberus expects that control of a privately owned Chrysler will allow it so much operational flexibility that it’s willing to pile leverage onto the automaker’s balance sheet in order to achieve the returns it seeks. If it makes this work, Cerberus stands to make a killing; in its view, the potential returns are worth the risk.
I doubt this is the case for those providing the $62 billion worth of credit to fund the deal. They’ll be receiving bond-like returns while taking equity-like risk. If the deal doesn’t work out, they could end up losing a huge chunk of their principal.
I’m confident that Cerberus will structure the deal so that it protects its interests first under all scenarios -- this may include the immediate payment of a dividend to itself or structuring the bond offering as one of the “covenant-lite” variety.
Covenants are restrictions and benchmarks that creditors impose on corporate borrowers to protect their claims on company assets, rather than allow their claims to be diluted by shareholder actions (in the case of Chrysler, Cerberus is the leading shareholder and those buying the $62 billion worth of bonds are the creditors).
Demand for “covenant-lite” loans reached a crescendo in the first half of 2007, but now appears to be waning. The Economist article describes this development:
“The place to look for a decisive shift in sentiment [toward junk bonds] is in the buyout market, which has been fueled by a trio of habits that in more sober times would have had lenders reaching for the Alka-Seltzer.
“The first of these lies in the burgeoning market for ‘covenant-lite’ loans. Loans normally require borrowers to maintain financial thresholds, like limiting debt to 5 times cash flow. But a huge number are now lacking such ‘maintenance covenants,’ which means that banks have less grip on borrowers when business turns sour. The total amount of covenant-lite loans issued in the first two quarters of 2007 has been $105 billion, which tops the $32 billion of all such loans written from 1997-2006 [emphasis added], according to Standard & Poor’s, a rating agency.
“The largest issuers of the covenant-lite loans are private-equity firms, which have been able to dictate terms to lenders. Kohlberg Kravis Roberts (KKR), a big buyout firm, filed to raise a record $16 billion of such loans last month to finance its buyout of First Data. Covenant-lite loans now account for almost 35% of all loan issuance in America.”
Covenants can require the borrower to maintain a cap on debt-to-cash flow ratios (aka “leverage”), or forbid the borrower to make dividend payments or repurchase stock. Creditors don’t like to see big dividend payments extracted out of the company that owes them money; every dollar that’s paid out as a dividend is a dollar that can’t be used to pay them back.
But loose or nonexistent covenants are not the only evidence that creditors have been ignoring their own interests. “Some firms bought by private equity have been issuing payment-in-kind (PIK) notes. These allow them to pay interest in the form of further loan notes, rather than hard cash.”
This is little different than a household making mortgage payments with a credit card rather than a checking account.
It’s hard to imagine a more egregious malpractice on the part of the creditor. Yet up until recently, creditors have been accepting PIKs in lieu of interest payments without fully recognizing that PIK notes are basically a sign of corporate distress.
The bottom line in this whole situation is that the claims on corporate America’s assets and cash flows have been sliced up and divvied out among all sorts of exotic securities at an unprecedented pace. This situation -- where the ultimate lender is five or 10 intermediaries away from the ultimate borrower -- usually doesn’t end well. Somebody along the lending chain is going to get blindsided by losses on junk bonds. The original underwriter of loans is motivated by the quantity of deals he can underwrite, not the quality. They write loans, get them off their books, and start the process all over again.
By late summer, we may reach a point at which supply of risky corporate bonds temporarily overwhelms demand.
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