Spreading Caution

The credit market suffers from a spot of apprehension and indigestion.
Economist StaffJuly 30, 2007

Calling it a credit crunch might be an overstatement. But it does look like a credit squeeze. In recent years, investors’ enthusiasm for high-yield products has allowed borrowers free rein in the debt markets. Blessed by strong profits and buoyant economic conditions, companies seemed more than capable of paying back their debts; default rates have been remarkably low.

Indeed, such was the power of borrowers, private-equity groups chief among them, that they were able to dispense with the market’s traditional safeguards. They dropped some of the covenants that gave lenders the right to act if the borrower’s finances deteriorated.

Suddenly, however, investors are turning their noses up at some deals. Banks that had lent large sums to finance the buy-out of Chrysler, the car giant, and AllianceBoots, the drugs retailer, had hoped to sell these loans to an eager market. This week both debt sales were postponed in the face of sniffy investors. A similar sale to fund the buy-out of US Foodservice, a food distributor, was scrapped last month. Even before the latest news Baring Asset Management counted 28 corporate-bond or loan deals, worth around $17 billion, that had been pulled since June 22nd.

What has prompted this change of heart? Many point to the problems in the American subprime-mortgage market, where defaults have risen and several hedge funds have been wiped out in the process. Countrywide, a mortgage bank, has triggered further concerns by admitting that bad-debt problems are now spreading to conventional loans.

When investors suffer losses in one part of their portfolio they get nervous about potential problems elsewhere. On July 20th the European crossover index, which covers riskier corporate debt, suffered the worst day in its short history. The spread (excess interest rate) over government bonds widened by two-fifths of a percentage point.

Investors may also be suffering from indigestion. According to Moody’s, a rating agency, nearly $1 trillion was raised in European credit markets in the first half of the year. Greg Peters, a Morgan Stanley strategist, says that $57 billion of bonds and more than $200 billion of loans are already in the pipeline: a plentiful supply of debt to absorb the potential demand.

It is hardly surprising, therefore, that investors have decided that higher yields are needed. This has caused a temporary hiatus as issuers get used to the new regime. But it looks more like a return to normality than a buyers’ strike. Credit-default swaps (which insure investors against a failure to repay) reflect this shift in sentiment. Jim Reid, the credit strategist at Deutsche Bank, says swap spreads in the European high-yield market are now wide enough to compensate for the average historic default rate. In America spreads are well above that level.

Pushing spreads further might require some actual defaults. That, in turn, would probably require the global economy to weaken significantly. At the moment, however, economists seem pretty sanguine, forecasting output growth of 2.7% for America in 2008 and 2.3% for both the euro area and Japan.

A benign view of the economic outlook may be why the Dow Jones industrial Average recently passed the 14,000 level for the first time. But stockmarkets have shown signs of concern at developments in the credit markets; their latest wobble was on July 24th.

Some of the fundamental supports for equities are being eroded. In America, corporate profits are on course to grow by 5.5% in the year to the second quarter, a long way below the double-digit rises to which investors have grown accustomed. The proportion of firms beating expectations in the second quarter was at its lowest since late 2002. By the measure derived from America’s national accounts, profits fell in the fourth quarter of 2006.

And the takeover boom may be near its peak. “The tide appears to be going out for leveraged equity financiers,” says Bill Gross of the bond giant Pimco. Bids have become more expensive to finance while share prices have been rising. Citigroup says that, in mid-2005, the corporate-bond yield was 4.4% and the trailing earnings yield on European equities was 6.8%. That made it highly attractive to issue debt to buy shares. But by mid-July the bond yield was 6.1% and the earnings yield 6.3%, a much less attractive trade.

Predators can be inventive in finding sources of finance for their deals, as Barclays has shown. At the margin, however, bids are becoming harder to pull off. The banks are now stuck with the risk of the AllianceBoots and Chrysler deals. They won’t want to make that mistake again.