Capital Markets

You Only Give Me Your Funny Paper

Debt markets turn grouchy as creditors ask for more.
Economist StaffJune 28, 2007

Before the brain was established as the body’s ruling organ, the stomach was thought to be king. Descartes may have thought and therefore known that he was, but he reckoned that most of his moods were regulated by his guts. Credit markets seem never to have adjusted to this reordering, and still think with their stomachs. This week they were grumbling, and several big bond sales were postponed until they settle. “It’s not a buyers’ strike,” says Paul Read, a bond fund-manager at Invesco, “but a bit of indigestion.”

Until two Bear Stearns hedge funds got into trouble last week, things had been bubbling along merrily in the credit markets. Last year default rates on high-yield bonds fell to their lowest since 1981, according to Edward Altman of New York University. They have stayed low this year and, with healthy corporate profits and plenty of liquidity, there is no reason to suggest that is about to change.

Even so, there are signs that 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 Arcelor-Mittal, the world’s largest steelmaker, put back a bond sale too. US 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.

Although modest repricing is going on, investors are still willing to take risks if they are paid a little more to do so, and plenty of deals are still going ahead. Yet all is not well. “There’s so much leverage in the system that it wouldn’t surprise me to see more problems,” says Jim Reid, credit strategist at Deutsche Bank. The place to look for a decisive shift in sentiment is in the buy-out market, which has been fuelled 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 five times cashflow. 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 to 2006, 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 buy-out firm, filed to raise a record $16 billion of such loans last month to finance its buy-out of First Data. Covenant-lite loans now account for almost 35% of all loan issuance in America. Many such loans are issued as senior-secured debt by stronger borrowers, making many of them safer than sub-prime residential mortgages.

Buy-outs financed by covenant-lite loans are less likely to fail early (there are, after all, no covenants to break as the company deteriorates). But if a wobble in asset-backed securities caused investors to demand more to hold them, the buy-out market would suffer. Only last week Thomson Learning, an education business, found it surprisingly hard to issue covenant-lite loans as investors grew squeamish.

A second place to watch for changing appetites to risk is in bridge finance. Up until last year, when a buy-out fund wanted to bag a big company it usually had to club together with other funds to increase its firepower. Now it is the norm for banks to provide bridge loans or equity to finance part of the deal. Through bridge equity, Blackstone was able to swallow Equity Office Properties, a property business, without installing too many cooks in the boardroom or having to share its ideas with competitors. This arrangement suits investors, who run the risk of being exposed to the same deal from several angles when private-equity funds club together. As a further inducement, bridge-equity finance also increases what those hard-up folk at Blackstone can expect to make on any upside of their deals, since they get the carry on the bridge-equity too.

The banks collect fees for raising the finance and for syndicating it. Bridge-equity finance can also be a way for them to get exposure to private equity. But, like supermarkets piling up discounted DVD players at the front of a store in the hope of luring customers in to splurge on cream cakes, the banks hope that funds who take these loans will go on to buy advice on mergers and debt-financing too, at which point the banks make their real money. If it goes wrong, they get left holding the equity.

Not all bankers think this is a good trade. “It’s an appalling business for the banks,” says a banker at a bulge-bracket firm more used to taking risks than balking at them. “It is the wrong use of your capital,” Klaus Diederichs of JPMorgan said at a seminar on June 26th. “It’s crazy and we hope it goes away.” Perhaps this wish is already being fulfilled. The day before he spoke, managers at a big private-equity fund based in New York were muttering in their Monday morning meeting that such loans were becoming harder to come by.

That leaves a third bellwether for the buy-out market. 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 further weakens the hands of creditors, adds to the sum of risky paper blowing around and makes investors wonder who owes money to whom. Harsher terms on PIKs would be further evidence of a shift in sentiment. Potential buyers of US Foodservice’s debt reportedly balked at both the PIKS and also the lack of covenants.

There are other indications that the appetite for risk is heading down, albeit from somewhere a few thousand feet above the peak of Everest. On June 27th the VIX, a measure of stockmarket volatility (otherwise known as nervousness), rose to 19%. It has been higher only once this year. The yen has appreciated, which is a sign that the buccaneering spirit reflected in the carry trade is waning a little (since unwinding this trade involves buying the currency). After lurching upward in early-June, the yield on American Treasury bonds has been falling, reflecting a stronger demand for safe investments. And spreads on high-yield bonds have widened. None of which means disaster is on the way. But it may leave a sickly feeling, something like a knee to the stomach.

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