It’s not as if finance is at a loss for mysteries these days: We’re having trouble explaining everything from last week’s flash crash to the subprime crisis of 2007. But even among financial mysteries, there is one I find particularly vexing: the current pricing of junk bonds and leveraged loans.
They’re doing great. Too great, in fact. Leveraged loans have returned 5.25% this year, according to Standard & Poor’s LCD loan index. And they’re booming in size as well as price: Bloomberg says junk-bond underwriting has quadrupled so far this year compared to the same time in 2009, to $91.8 billion. Since the Freeze of 2008, demand for leveraged loans jumped nearly 70%; the resurgence of big buyout talk shows the willingness of banks to lend to private equity firms. Silver Lake and Warburg Pincus will borrow $2 billion of IDC’s $3.4 billion pricetag.
Financing is so easy that even the much-maligned dividend recap is back. S&P Leveraged Commentary and Data shows that LBO financing increased by 15 times this year so far compared to the same time in 2009.
Mind you, there’s already plenty of supply in the market: Private equity firms announced $1.7 trillion of buyouts during the LBO boom of 2005 to 2007. All this has created a wall of debt that is approaching in 2011. We’ve been able to chip away at because of the ease of financing this year, but nonetheless it is still a thick, giant wall.
All this already looks like a recipe for disaster. There’s more. In the best evidence yet that no one is minding the store, PIK toggles appear to be back. Paying off loans with more loans, while the economy is coming out of the worst financial crisis since the Depression, doesn’t exactly seem like the most logical move – even if interest rates are at zero. So far, the first company to use a PIK toggle this year isn’t troubled, according to Deal Journal. Now that the option is out there again, however, how long will it take for more troubled companies to run for the PIKs? Not long.
All this is happening as private equity’s boom-time failures pile up. Private equity firms have been forced to euthanize debt-ridden portfolio companies in large numbers by sending them to bankruptcy. By Thanksgiving of 2009, over 62 private equity-owned companies had gone bankrupt. Companies that are bankrupt now are issuing junk bonds freely to exit, but they may not have that option for long.
That leads us to the big question: What’s driving this rally? Given the economy, it doesn’t look like what money managers call “fundamentals.” Companies are still reeling from the crisis, consumer spending is still low, the availability of credit to both consumers and most companies is in the ditch, and signs of any recovery are tenuous at best. At the same time, the sovereign-debt crisis that has plagued European countries is a valuable lesson – if any is needed – about the dangers of debt.
The rush to refinance old corporate debt is, of course, part of the reason for the rude health of the junk market. There’s that $1.4 trillion wall of debt out there, and companies are hurrying to pay it off before the markets close again. That trend doesn’t explain the willingness of banks to write so many new loans before the old ones have fully exited the system, however. After all, last time around the banks were left holding hundreds of billions of dollars of leveraged loans on their own books, dragging down earnings for years. Why sign up for that again?
Instead, look to another cause. Like the market for subprime loans, Internet stocks – or indeed, any bubblicious-looking market – the “frenzy” over junk bonds is driven by a wealth of buyers. Just as the subprime crisis taught us, where there are buyers, Wall Street will invent a product for them. The more buyers, and the less product, the lower the underwriting standards fall.
Many of these voracious buyers of junk bonds are affiliated with private equity firms. Remember, back in 2007 a number of funds popped up to buy leveraged loans. At the time, private equity firms considered their loans undervalued and hoped to save themselves money by acquiring the loans of their portfolio companies from cheapskate banks.
Those funds are still in action. Now, however, there’s a new, far more public face to it. No longer are the only players in junk bonds sophisticated investors who know how to understand that “high-yield” also means “high risk.” Instead, leveraged-loan funds from big institutional players will soon bolster themselves with money from retail investors.
For instance, Bloomberg reports that Blackstone Group’s GSO Capital is creating a mutual fund which will be 80% composed of loans rated below investment-grade. In Europe, the Financial Times reports that HarbourVest is listing a vehicle for European leveraged loans.
This is troubling. Leveraged loans are at a dangerous point in their lifecycle. For private equity firms, it makes sense to get refinancings done as fast as possible. Given the historical evidence and the wounds of the subprime crisis, however, it’s foolish to trust any weakly collateralized, highly priced security to keep rising in value. Magical thinking and widespread delusion generate awful returns when the crash comes.