Wednesday, September 19, 2012

Short Attention Span Theater

The Credit Markets Are Starting To Get Stupid (Again)

Way back in January I discussed in some detail when investors would want to be in or out of the junk bond market (see ).  One of the most important things any investor in this market can do is know when NOT to be invested in junk, since owning junk at the wrong time can destroy quite a lot of value in a relatively short time period.  The hallmarks of a junk bond market that is starting to get overly frothy include excessively tight spreads over treasuries, high volumes of new bonds being issued, and increasingly lax structures that strip much of the protection afforded to investors by covenants and other features of these securities.  You might be inclined to think that after the horrendous debacle of 2009 the credit markets would exercise some discipline for a long time.  There is increasing evidence that you would be wrong to think that.

First, junk spreads have slid significantly in recent weeks.  The BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread index now shows junk bond spreads hovering just above 5% above treasuries of similar maturity.  This isn't at all time lows of less than 3%, but it is low enough that anyone thinking about buying junk for yield should think twice about doing so.  Given the substantial increase in risk, all of a sudden would-be junk investors are being compensated at relatively low levels.  Sub 5% spreads mark the point at which I personally am not eager to buy any junk and when I start thinking about selling.

Second, issuance volumes have been high over the course of the summer and they have increased their pace in September thus far.  Across the spectrum of credit from the cleanest investment grade names to Caa/CCC-rated junk, new bonds are being pounded out every day.  Even issuers whose debt is not callable are rushing to refinance now that the market is accomodating.  For example, B-rated American Axle (AXL) recently successfully refinanced its 2014 bonds by issuing new long term bonds and conducting a tender offer for its non-callable existing bonds.  When issuers that have been junk rated for a long time start rushing to refinance, it isn't because they just feel like doing so.  Generally these types of issuers are long term observers of the junk market and understand very well that the market only gets this loose for a limited time.

Finally, terms and conditions have begun to get extremely aggressive in new junk issuance.  Covenants and other measures are important protections for investors in junk bonds, as they force an issuer to deal with problems sooner rather than later and usually keep the management of a troubled company from "putting it all on red" and try to gamble their way out of a mess using the bondholders'/lenders' capital.  Unfortunately, when the junk bond market gets frothy issuers are sometimes able to dispense with many or even all of these restrictions.  As a prime example, AdvancePierre Foods is said to have been in the market today with a new syndicated loan which is of the "covenant lite" variety.  This debt apparently was priced at 4.75% over LIBOR with a 1.25% LIBOR floor (all in yield of 6%) that matures in 4 and 3/8 years.  This $825MM issuance has little or no covenant protections for the investors buying the loan, so the management of this privately-held leveraged buyout company can do pretty much what they want as long as they make the contractually scheduled payments on this loan.  The proceeds paid off existing loans, but they also funded a dividend to the owner of the company.  So a B-rated issuer was able to sell close to $1Bn in loans that have almost no protections for the investors and they were allowed to pay out a chunk of the lenders' money to the equity investors.  For all of this lattitude they will pay a 6% yield.  This is a pretty aggressive structure, and if we see more issuance like this and possibly some spillover from the leveraged loan market to the junk bond market, it will be a very clear sign that investors should resist the temptation of yield and get out of the junk market.

Investors should watch developments in the credit markets carefully in coming weeks.  More aggressive behavior will be a clear sell signal, especially if spreads continue to drop.

Lest this just be about doom and gloom, I would offer you a silver lining from increasing stupidity in the junk market.  The last time the credit markets got dumb, the equity market benefitted.  Specifically, credit was so readily available and cheap that lots of mergers and acquisitions that would never have otherwise been possible got done.  Accordingly, after a number of transactions where either other companies in the same industry or leveraged buyout funds took over targets at a significant premium to market values, the market begain pricing in higher valuations for a number of sectors.  This had a stimulative effect on equity valuations and if you happened to be an investor in one of the "loved" sectors or in one or more takeover targets, you got a strong tailwind on your equity portfolio.

As always, the above is not intended to be investment advice.  Consult your advisors, be careful, do your own due diligence.

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