Credit and Macro - Fluctuat nec mergitur

"The human race's prospects of survival were considerably better when we were defenceless against tigers than they are today when we have become defenceless against ourselves." - Arnold J. Toynbee, British historian.

While still reeling from the outrageous Paris attacks (one of us being a "born and bred" Parisian), and, looking at the continuous rally in risky assets, for our chosen title and in homage to the numerous victims of this senseless act, we decided that our chosen title should reflect Paris, hence our election for Paris coat of arms' motto "Fluctuat nec mergitur". It was officially established on the 23rd of November 1853 but dated back from at least 1358, a coincidental "number anagram". This motto could be translated as follows for Paris: "Paris is tossed by the waves but does not sink". 

When it comes to our analogy, Paris is like credit, resilient, it is tossed by waves but does not sink as reflected in the below graph from RBS The Revolver note from the 17th of November:

- source RBS

As we move towards the end of 2015, when it comes to credit European High Yield in the credit space has clearly outperformed US High Yield and even US Investment Grade. In this week's conversation, we would like to look at the prospects for credit for 2016 as well as pointing out some additional signs of credit cycle exhaustions as of late which, we think, warrants further monitoring.

Synopsis:

• LBO fatigue - yet another additional "caution" sign of the "credit cycle"
• The US High Yield Market continues to be heading "South"
• What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?
• Final chart - Q4 US consensus profits growth is already forecast to be negative

• LBO fatigue - yet another additional "caution" sign of the "credit cycle"

Whereas in recent weeks/months we mused around our favorite credit indicator for the lateness in the "credit cycle" being the "CCC Credit Canary" and its issuance issues, we also recently questioned ourselves in our conversation "Liebig's law of the minimum":

"Looking at the acceleration in M&A activity in recent days (DELL, AB InBev, etc.), which amounts to us, as yet another indication of us being in the last inning in the credit cycle, it appears evident that while credit corporate bond markets remain wide open, the last two months have shown clear signs of some form of "exhaustion" in the cycle, particularly for High Yield. It remains to be seen which next M&A deal or LBO will fall through." - Macronomics, October 2015

Indeed, whereas we have seen an acceleration in large M&A transactions, the continuous struggle of the "CCC Credit Canary" and the rise in the "cost of capital" have finally taken their toll and translated into the LBO market as shown in the  recent comments below from SG US derivatives desk highlighting that once again "weak feeling" we have on US HY credit markets, following a quickly erased October rebound:

"This week surprisingly weak demand for financing of the LBO of Veritas caught banks by surprise. The consortium led by Bank of America and Morgan Stanley ended upstuck with $5.6bl of the debt as they were forced to postpone the offering, even after they offered a discount to investors and a yield as high as 11%. The consortium of banks will now have to the debt on their books and wait for a more opportune time to sell the high yield debt. Earlier this year a group of Private Equity investors led by Carlyle agreed to buy Veritas from Symantec (SYMC) in an $8bl Leveraged Buy Out, the largest LBO of 2015.
The high yield debt market has seen stress from the energy sector, where default rates have risen to 8.2% last month from <1 beginning="" in="" nbsp="" of="" span="" style="color: red; line-height: 20.8267px;" the="" year.="">The stress seems to spread to other segments of the high yield market, as demonstrated by the failure to place debt of a tech company and a overall widening of spreads of risk free rates.

 

We launched an High Yield Thematic basket (SGUSHY Index) last week that replicates the HYG, but holds the stocks instead of the corporate bonds of the issuers in the Markit iBoxx High Yield index. The basket therefore offers a much more attractive transaction costs (1mL – 30 financing costs vs. 90bp borrowing rates for HYG (indicative prices))." - source Société Générale

For us, it was interesting to see the difficulties of the Veritas LBO refinancing deal, far away from the struggling oil sector. Different times, different situations, but some 2007 memories came to our mind, particularly when the first signs of the credit market peak came from a few struggling LBO refinancing deals at the time.

Within the general High Yield market tone of nervousness we also noticed on the US Convertible markets in the last few day some several "massive" spread widening moves, especially on the High Y iled "renewable energy" segment:  SUNE, SCTY…

 SPX vs US HY ETF HYG - source Bloomberg:

- graph source Bloomberg.

Also, we are also wondering about the increasing number of cash M&A deals met with market skepticism (with acquirers shares selling off on the announcement: ON Semi/Fairchild and Air Liquide/Airgas yesterday, Mylan/Perrigo and Dialog/Atmel situations in the last few weeks…). Are we seeing some signs of fatigue? It certainly looks like it to us.

In conjunction with LBOs losing their "mojo", flows have well have finally shown some signs of pause after the significant inflows we described in October. For instance, as shown in Bank of America Merrill Lynch High Yield Flow report from the 12th of November entitled "The pendulum swings for HY ETFs",  the rally experienced throughout October in terms of inflows have come to an end:

"High yield fund flows reverse trendUS high yield saw its first week of outflows (-$1.61bn) in 6 weeks with both ETFs and non-ETFs ending up in the red. HY ETFs saw a massive $3.91bn WoW swing with a- $1.37bn (-3.5%) outflow this week, while non-ETFs saw a less volatile $242mn (-0.1%) net outflow. These outflows from ETFs are not surprising given the nearly 17% AUM growth the asset class has seen over the previous 5 weeks. Additionally, as we have previously discussed, investors likely grasped at the opportunity to sell into the recent rally and lock in October’s impressive 2.73% return.Meanwhile, non-US high yield funds saw $1.08bn (+0.4%) in net inflows. Outside of high yield, high grade funds continued to grow their asset base with an $828mn (+0.1%) net inflow, their 5th consecutive weekly inflow. Loans posted yet another outflow ($347mn, - 0.4%), to bring their YTD %NAV to an even -11%. EM debt saw net outflows of -$1.2bn (-0.8%), likely suffering from the ever-increasing probability of a December rate hike. As a whole, fixed income funds saw -$3.30bn (-0.2%) in net outflows, their first weekly outflow in 6 weeks. Equities saw little change with a minor $2.41bn (+0.0%) inflow.

- source Bank of America Merrill Lynch

Whereas for US Investment Grade, we still believe in a "Fluctuat nec mergitur scenario for 2016, where a rising US dollar and "external" allocations (such as Japan's GPIF) to US credit should continue to be supportive of the asset class, we are getting more and more concerned on US High Yield with the accumulations of warning signs we are seeing. This brings us to our next bullet point.

• The US High Yield Market continues to be heading "South"

More concerning to us as (apart from "inflows" and "outflows in High Yield) has been the flattening of the US High Yield CDS curve as shown below from CMA part of S&P Capital IQ for the CDX HY Series 25:

As of per the 19th of November 2015:

As of per the 1st of October 2015:

- source CMA part of S&P Capital IQ

This, for us is yet another clear sign of deterioration whereas Investment Grade continues so far to benefit from a steeper credit curve despite market expectations of a rate rise in December by the Fed.

We are not alone to have a "negative stance" on US High Yield, we also share the same concerns as Bank of America Merrill Lynch from their HY Wire note from the 16th of November entitled "Bonds to underperform loans again in 2016":

"Fool’s gold
Several weeks ago we mentioned that taking part in the October rally was a fool’s errand, and that the inflow of cash to primarily ETFs was responsible for the bottom fishing that occurred in the first two weeks of the month. In our view, selling into the strength, despite high cash balances was the prudent move- a position we continue to like today headed into year end.
The payrolls number from two weeks ago coupled with further weakness in fundamentals and commodities, disappointing retail sales and relatively hawkish comments from Chairwoman Yellen have created a perfect storm of worry among high yield investors, as our index has retraced almost 50% of the gain from last month (Chart 1). 

And for good reason too. Our house view is for the Fed to raise rates in December and it appears as though the divergence of the US economy from high yield fundamentals isn't changing anytime soon as Q3 earnings mark a 5th consecutive quarter of weakness. EBITDA growth for a third of the HY universe that has reported so far is still negative, and adjusted EBITDA growth is near zero (Chart 2).

And unfortunately, it’s getting increasingly harder to push the blame for dismal HY earnings on the strength of the dollar.

Furthermore, geopolitical headwinds still exist, and, liquidity (or perhaps the better word is "reality" as in the reality of the real prices in which bonds can trade) continues to present challenges. To make matters worse, we can't say we love quality here either though clearly given our disposition leaves us the least ill when thinking about positioning in a must invest world. Meanwhile triple Cs and single Bs are not the place to hide with just a few trading weeks left in the year. As such, expect next to no bid on any new deals with hair on them and for higher quality new issue to be the place to hide and put cash. Finally, despite loans holding up so well to bonds this year, we continue to like loans heading into 2016, and discuss below in detail some analysis that draws us towards that conclusion. " - Bank of America Merrill Lynch

Exactly. Going higher into the quality spectrum in US High Yield is a imperious necessity as we are witnessing a clear deteriorating trend in the "credit cycle". 

What interesting is that investors (or "yield hogs") seems to continue in many instances to disregard "safety" for "yield "as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 13th of November entitled "Yield is king":

"More in yield, less in “safety”Investors continue to embrace yield over “safety” for a fifth week in a row. Both high-yield and equity funds continued to see more inflows last week. On the contrary, flows into high-grade slipped back into negative territory. Likewise for government bond funds.
Optimism on the back of the previous week’s high grade inflow did not last long as the latest data shows; flows dipped back to negative. Nevertheless, note that high grade ETF fund flows remained positive for a fifth week in a row.

Looking at high-grade duration, both short and long-term fund flows turned negative during the previous week, while mid-term fund flows remained positive but only marginally.
A positive trend however continues in high yield, with the third consecutive week of $1bn+ inflows; the fifth inflow in a row. Last week’s flow also brought the year to date inflow for the asset class back into positive territory.
Government bond fund flows, on the other hand, moved deeply into negative territory suffering the biggest outflow in 19 weeks. Money market funds followed a similar path, but less extreme.
The week in fixed income flows therefore finished in negative territory, marking the first outflow in five weeks. YTD flows into FI funds are now negative.
 Looking at equity fund flows, the trend remains strongly on the positive side for the sixth consecutive week. YTD flows are now at $110bn+." - source Bank of America Merrill Lynch

Whereas, 2014 was not the year of "Great Rotation" from bonds to equities, 2015 was clearly supported by flows particularly in Europe thanks to the "divine" intervention and meddling of central bankers. This is leading us to our third point, namely what to expect in 2016, will it be "Fluctuat nec mergitur" again for credit?

• What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?

This is particular true in Europe which, performance wise, was clearly supported by the actions of "Le Chiffre" aka Mario Draghi as indicated in Société Générale in their note from the 12th of November entitled "Risk Premium in Pictures ":

"Digging into corporate bond valuationsAt a time when the US Fed is expected to embark on the journey of normalising its monetary policy, we analyse the relative valuation of equity, corporate credit and government bonds.
With the exception of eurozone equities, most asset classes have delivered lacklustre returns in 2015. Rich valuations, a potential Fed rate hike and a slowdown in Chinese growth has weighed on asset prices this year. However, consistent with our constructive stance on eurozone equities, 2015 has indeed proved to be a fine vintage for eurozone equities.

Be ready for lower returns going forward. 

In the left-hand chart below, we plot the total return investors should expect across asset classes. Our proprietary risk-premium model suggests that most asset classes will deliver single-digit sub-par return going forward. 

However, it is clear that equities are expected to do well relative to fixed income assets. Within equities, we expect the euro area to perform best as growth expectations improve from the current bearish level." - source Société Générale

While we continue to expect Europe to outperform High Yield wise the US from a "relative value perspective", the actions of the ECB continues overall to be supportive of credit in Europ particularly in the light of continuous "financial repression", rising amount of short term negative yields in the continuation of the "Japanification" process. 

Credit wise, we are moving from a story of convergence, to a story of divergence, some would point out this is very "2011ish" in credit, but it is the reality, as the Fed and the ECB are set up for different courses. This was clearly indicated by the latest post from DataGrapple:

"The FOMC minutes released yesterday confirmed that the Fed are still on course to raise rates in December. Specifically, it was noted that “while no decision has been made, it may well become appropriate to initiate the normalization process at the next meeting”. Based on the Fed fund future market, the probability of a hike stands at 68%, but hardly anyone doubts that will go ahead. That is in stark contrast with expectations regarding the ECB next course of action. QE expectations in Europe are as high as they have ever been and investors are bracing themselves for a salvo of new easing measures mid-December. It will be the first time in a long long while that central banks in Europe and in the US embark on radically diverging paths. These contrasting environments are being played by credit investors, and some today were buying protection on CDXHY in the US while selling protection on iTraxx Crossover. Generally speaking, relative values are being played and it is obvious for all to see on the above grapple. While CDXIG and iTraxx Main (ITXEB) were trading 1bp apart at the beginning of October (at 96bps and 95bps respectively), they were trading 7bps apart early November (at 78bps and 71bps respectively) and stand 12bps apart at the close (at 84bps and 72bps respectively)." - source DataGrapple

This divergence, we think, will continue to play out in credit, from compression and convergence to decompression and divergence. Please find below our illustration on this subject - CDX Investment Grade US versus Itraxx Main Investment Grade Europe (roll adjusted) - data source Bloomberg:

- source Bloomberg - Macronomics

In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan". 

Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team and the below graph from their report European banks from the 13th of November entitled "A wake-up call":

"Top picks 

We are Overweight European Banks. There is value, with over half the sector (and €600bn of market cap) now trading below TBV. The earnings momentum has stalled post Q3, and banks need to wake up to the new reality of revenue stagnation. Restructuring and a focus on isolated areas of revenue growth will help. This can be supported by increasing capital strength. Our Top 5 list outlines the banks that can best benefit from these themes: Barclays, Erste Group, ING, Lloyds and UBS. We remain cautious on BBVA, CS, DBK and Nordea.

- source Société Générale - SX7P = Eurostoxx 600 Financials vs Eurostoxx 600 = SX7E

No "offense" to the equities guys but here are some facts about the banking system in Europe still being "capital impaired" as indicated by Linklaters on the 2nd of November:

• Estimated €826bn of NPLs are currently sitting on the balance sheets of European banks that are supervised by the SSM

• NPL volumes still remain close to levels revealed at the ECB’s comprehensive assessment in 2014

• Significant differences between NPLs across different countries with high volumes in place across Italy, Spain, France and Greece

• Greek, Austrian, Portuguese, Italian and Cypriot banks likely to be challenged further in future stress test

New analysis from Linklaters estimates that since the ECB’s Single Supervisory Mechanism (‘SSM’) was implemented on 4 November 2014, non-performing loan (‘NPL’) volumes across the banks it supervises remain high, reducing marginally from €841bn* to €826bn**. 

The NPL to Asset Ratio of these banks has also only slightly decreased from 4.13% (end of 2013) to 3.92% (H1 2015). 

Banks have been announcing plans to offload NPL portfolios and demand continues to be significant from investors with at least €40bn*** of distressed funds raised to buy these portfolios. But the research suggests that NPLs in certain countries are steadily increasing, causing a drag on banks’ profitabilities and market confidence. Tackling these credit risks will be a key supervisory priority for the SSM in 2016." - source Linklaters

No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016 as well as shown in the never ending earnings revision in the sector as displayed in the same Société Générale report:

- source Société Générale.

So if you want "Fluctuat nec mergitur", when it comes to "banks" exposure in Europe, stick to credit.

In the end for credit, and markets, leverage matters, financial credit conditions matter and so does earnings for any rally to be sustained.

• Final chart - Q4 US consensus profits growth is already forecast to be negative

Whereas during most part of the summer we have been musing around the credit cycle, leverage, defaults and indicators, more recently we have touched on the deteriorating picture and risk of "peak profitability in the US", earnings, regardless of the surge in the US dollar are facing "headwinds" and this, we think is linked to global financial conditions tightening. For our final chart, we would like to point out the fundamental problems facing equity investors given the weakening earnings picture. This is clearly illustrated by the below chart from Société Générale Global Equity Market Arithmetic report from the 16th of November entitled "US profits facing numerous headwinds":

"Equity investors face a variety of fundamental problems, including higher levels of debt, expensive valuations and weakening profits. And whilst earnings momentum has turned up recently, as it typically does during the reporting season (and from very low levels), the proportion of downgrades coming through remains elevated and is only likely to increase in preparation for Q4 reporting. Notably Q4 US consensus profits growth is already forecast to be negative even once financials and energy are excluded.

US dollar strength is clearly already a problem for US corporates and weak US import prices are taking its toll on industrial profitability. However a strong US dollar is not necessarily a given post the first interest rate rise. A quick back of the envelope calculation shows that whilst the US dollar typically appreciates in the 3 months leading up to the first rate rise, in 9 out of the last 10 interest rate cycles the US dollar was weaker in the 3 months thereafter." - source Société Générale

Remember when everyone is thinking alike, no one is really thinking...

"We cannot solve our problems with the same thinking we used when we created them." - Albert Einstein

Stay tuned!

LBO? No problemo!

"No problemo" is a slang expression used in North American English to indicate that a given situation does not pose a problem. It has roughly the same meaning as the expression "no problem," but is rarely heard as a response to "I'm sorry." - source Wikipedia

While looking at the quick succession in LBOs (Dell, Heinz), a subject we have tackled with Dell recently in our conversation "The return of LBOs - For whom the Dell tolls", as a credit investor, the "sucker punch" capacity of inflicting serious pain to the investment grade bondholder is reminiscent of the hay days leading to the burst of the credit bubble in 2007.

In similar fashion to the Dell transaction, the Heinz effect was rather more sanguine than ketchup, and probably as spicy as tabasco when it comes to spicing things up a bit in the CDS space - source Bloomberg:

From 50 bps to 200 bps, given Buffett's new found love for the ketchup is transforming H.J. Heinz into the most leveraged food maker in America as reported by Mary Childs in her Bloomberg article on the 21st of February - Buffett’s Ketchup Fancy Plies Heinz With Junk:
"Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc.’s $23 billion acquisition of Heinz may double the company’s total debt to five times earnings before interest, taxes, depreciation and amortization, according to Fitch Ratings, the highest of any comparable food company. The cost to protect Heinz’s debt from losses soared to a record after the announcement. While Buffett has used takeovers to build Berkshire into a $249 billion company and burnish his reputation as the world’s most successful investor, financing the deal with $14.1 billion in debt threatens to strip Heinz of the investment-grade rating that it’s had for four decades. Fitch cut Heinz to junk on Feb. 15 and credit-default swaps imply a Ba1 rating, according to Moody’s Corp.’s capital markets research group. That’s two steps lower than its Baa2 rating from Moody’s Investors Service and three below its BBB+ grade from Standard & Poor’s. The trading “underscores the hazards of high-grade bonds in an active M&A environment,” said Martin Fridson, chief executive officer of research firm FridsonVision LLC. Investors should be aware of the “inherent danger now that leveraged buyouts as well as strategic acquisitions are once again prominent in the financial landscape,” he said." - source Bloomberg.

The cheap credit environment is indeed sufficiently friendly for shareholders in this on-going releveraging process and arguably very unfriendly and painful, to say the least, for the investment grade portfolio manager, given that the LBO story is clearly more favorable to equity investors than credit investors facing multiple downgrades and Profit and Loss hits.

In a recent note by CITI entitled "Ever Been a Better Time for a LBO?" published on the 22nd of February 2013, they argue that the current cheap credit environment makes the pursuit of shareholder-friendly activity quite compelling relative to historical norms:
"Question: If you could buy the exact same company for $75 today (sale price) or for $100 tomorrow (full price), which would you chose?

Answer: Depends. Paying full price may very well be better than paying the sale price if borrowing costs for the two are different. Price is one part of the “package.”

When considering re-leveraging activity, our sense is that many market participants tend to overlook the “package effect,” and as a result under-appreciate the extent to which corporate managers could favor shareholders. In fact, in a sum-of-the-parts context the argument for LBOs may look as compelling as it ever has." - source CITI

As we have also argued in our conversation "Bold Banking", when one looks at the return of Cov-lite loans to the fore front, no doubt to us we are entering, once again bubble territory in the credit space. In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."

"Low borrowing costs: Current borrowing costs are hovering near all-time lows. For example, a typical LBOed company is likely to carry a single-B rating, and Figure 2 (previous page) shows that the yield for the average single-B issuer is almost 4% below the historical norm (5.9% vs. 9.8%). Also noteworthy is that moving from single-A — the typical rating of an “un- LBOed” company — to single-B (likely post-LBO rating) is fairly cheap as well. Figure 3 (previous page) shows that the yield difference between the two is now only 3.4%, vs. the long-term average of 4.7%. And there are other lending features in the current environment that in practice cheapen borrowing costs as well, such as the relative lack of covenants (Figure 4). It really doesn’t seem to cost that much to move down the quality now." - source CITI

The "unintended" consequences of ZIRP courtesy of the Fed is favoring releveraging of corporates' balance sheets:

"Reasonable valuations: So an LBOed company in the current environment can be expected to provide a high income stream due to low interest expense, and equity stakeholders may now have an above average chance of collecting this income stream. But in addition, one also doesn’t have to pay all that much for these advantages; the PE ratio for the typical IG name is currently 12.8 (based on our sample universe as explained below), compared to the historical norm of 16.4 (Figure 6)." - source CITI

CITI goes further in their note displaying a real world example for the sake of the demonstration:

"Based on our sample universe, the typical “un-LBOed” company currently has $3.8 bn in total debt outstanding, current market cap of $13.8 bn, and earnings before interest of $1.8 bn (Figure 7). Given our assumptions, after an LBO this company’s equity value will decline by $9.6 bn and total debt will increase by the same amount." - source CITI

"Impact of low borrowing costs: If we consider an LBO scenario in a historical context borrowing cost rises from 5.1% (long-term average yield of the typical single-A issuer) to 9.8% (average single-B). Higher borrowing cost means that net income would fall from $1.58 bn to $0.45 bn for the typical name (albeit divided among fewer shareholders, of course; Figure 8). But currently all-in yields are low and the yield difference between the average single-A and single-B is only 3.4%, which means that interest expense rises by a fairly small amount (Figure 8, previous page). As a result, net income is not pressured by higher borrowing costs anywhere close to normal, and post-LBO net income is far higher than usual ($0.98 bn)." - source CITI

Given the pressure on CEOs to increase ROEs, the LBO can indeed justify the recourse in leveraging the balance sheet as indicated by the below table from CITI's note indicative of the potential increase of ROE that can be achieved via a typical LBO for an investment grade company:

"Pay less for more! One could normally expect the ROE for a typical company to be more or less flat post LBO (Figure 10). This is not all that surprising, as sponsors get paid to shift through the details. The multiple one has to pay for flat performance is normally 16.4x. But now the increase in ROE is over 11% in a post-LBO scenario (from 12.2% to 23.4%). And to get the relatively high ROE the multiple one must pay is lower than normal, not higher (12.8x vs. 16.4x)." - source CITI

As a reminder, in 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, but , as CreditSights put it in in their 29th of July 2008 report entitled LBO Analysis - It is more than Just Financial Metrics:

"Creating value by adding leverage is, in essence, an arbitrage strategy. And, like any arbitrage return, it will ultimately be arbitraged away as participants increase. 

Despite the favorable lending terms during 2005-2006 credit bubble, it stands that there is even less ability to create value simply from leverage.

LBO management can enhance value by exploiting knowledge of a competitor's play book when on the offense and by taking more financially productive responses when on defense." - source CreditSights

We could not agree more.

"What counts is what you do with your money, not where it came from" - Merton Miller 

Stay tuned!

US share buy-backs and dividends increases in two charts

"If you ask a firm's management, they'll likely tell you that a buyback is the best use of capital at a particular time. After all, the goal of a firm's management is to maximize return for shareholders and a buyback generally increases shareholder value. The prototypical line in a buyback press release is "we don't see any better investment than in ourselves." Although this can sometimes be the case, this statement is not always true." - source www.investopedia.com 

- Source - Societe Generale US Credit Research.

Increasing buy-backs in conjunction with rising dividends:

- Source - Societe Generale US Credit Research.

"The Bottom Line: Are share buybacks good or bad? As is so often the case in finance, the question may not have a definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback - and its effects - can be viewed as a positive sign for shareholders. Watch out, however, if a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution."  - source www.investopedia.com 

For us, buy-backs are credit negative if it means buying-back using leverage and more debt, particularly for banks given it reduces the equity buffer needed in case of trouble. 

Increasing debt to fund share buy-back is a trend we have seen lately. It might be more efficient from a tax point of view given interest on debt is deductible, but, remember, a debt has to be repaid at some point...

Share buy-backs do eat into FCF (Free Cash Flow). While we recently touched on the return of LBOs with the example of DELL inc ("The return of LBOs - For whom the Dell tolls"), from a credit perspective, in similar fashion to LBOs, the rising trend in share-buybacks using debt finance warrants close monitoring in this "Yield Famine" induced environment of "Financial Repression", where the "credit mouse-trap" has been set up by Central Banks.

"If you do not change direction, you may end up where you are heading." - Lao Tzu 

Stay tuned!

The return of LBOs - For whom the Dell tolls

"It was easier to live under a regime than fight it." - Ernest Hemingway, For Whom the Bell Tolls, Chapter 34.

"A leveraged buyout (LBO) is an acquisition (usually of a company but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explains the origin of the term LBO." - source Wikipedia

In the run-up to the financial crisis of 2008, 2006 and 2007 where the years where "cheap credit" fuelled the housing bubble, but it was the years as well of the mega-buyouts. In 2006, private equity firms bought 654 US companies for 375 billion USD, 18 times the level of 2003 and raising 215.4 billion USD in investor commitments to 322 funds. 2007 saw yet another record with 302 billion USD of investor commitments to 415 funds. 

The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  

Energy Future Holdings is loaded with 37.4 billion USD worth of obligations whereas Texas Competitive is saddled with 32.2 billion USD in debt, 700 million USD of which is due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 

KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp is moving towards bankruptcy and restructuring according to Bloomberg article by Richard Bravo and Mark Chediak - TXU Teeters as Firms Reap $528 million fees: 

"Energy Future’s long-term debt has soared to $42 billion since the buyout and the company is poised for its seventh straight quarterly loss as it struggles with natural gas prices 73 percent below their 2008 peak. Moody’s Investors Service says the company may need to restructure next year and derivatives traders are pricing in a 95 percent chance of default within five years for its deregulated unit." - source Bloomberg.

The issue with TCEH was that their breakeven cash flows needed in 2011 was based on 6.40 USD/mcf sustainable gas prices to cover all interest expenses and 450 million USD of maintenance CAPEX according to CreditSights calculations in April 2011. Of course it went horribly wrong for natural gas in 2012 and the "assumptions".

- source TradingEconomics.com

When too much leverage and when assumed breakeven on natural gas prices are so far out from reality, it does not end well for the TXU/TCEH bondholders and could get even uglier if natural gas price falls again towards the April 2012 lows...but that's another story and we ramble again...

Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with 1.5 trillion USD in assets that they intended to sell at a profit. For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council.

While we already delved into the insidious returns of cov-lite financing in our September conversation "The World of Yesterday":

"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance."

In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."

Back in February 2011, we also discussed the dangerous return of Cov-lite loans financing and we referred to what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, said in her article - Corporate Subprime - The default crisis that never happened:

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.

After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."

But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Old habits die hard:

"Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard and Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006."

The latest news surrounding the possibility for Dell to go private via the use of a LBO, have made us want to look into more details about the return of the LBOs, which was previously linked to the previous credit bubble. It was fuelled, in similar fashion by "cheap credit". 

Following a comment from Dave Merkel, writer of the Aleph Blog in relation to our post "Chart of the Day - S&P 500 pension equity allocation" ("Private equity is replacing public equity in many DB pensions. The "Chart of the Day" may not mean what you think."  - David Merkel), 

Here comes the time for us to go into the Dell case, and the unsurprising come-back of the mega-LBOs. So yes David, you are right, private equity and large LBOs are coming back with a vengeance.

During the run-up to the credit crisis of 2008, the impact of LBOs where not only a nightmare for investment grade credit portfolio managers given a LBO is by definition a negative credit event (more leverage with more debt on the balance sheet meaning an obvious fall in the rating spectrum), it was as well a nightmare for market makers in the credit space, natural sellers of CDS protection to their clients, given the "sucker punch" capacity and P&L pain infliction caused by widening CDS spread on LBO news such as the one relating to DELL. 

For instance, the latest news surrounding DELL have cause a serious "denting P&L" kind of spike in the CDS price - source Bloomberg:

This kind of "sucker LBO punch" significantly hurts your P&L if you have been a net seller of CDS protection on DELL in this tightening spread environment (+200 bps on 5 year...).

Sector wise, the result is similar, DELL has indeed widened significantly relative to some peers on the LBO news as displayed by the below graph of CMA, part of S&P Capital IQ:

The latest news surrounding DELL is that it has hired Evercore to seek higher bids should a buyout be formalised according to Bloomberg:

"Silver Lake and its partners are close to lining up about $15 billion in funds for a buyout of Dell, the third-biggest maker of personal computers, people familiar with the situation said last week. The deal would likely value Dell between $23 billion and $24 billion, said one of these people." - source Bloomberg.

A similar Texan company that went through a similar buyout than DELL, was Freescale Semiconductor Inc back in 2006 which was bought for 17.6 billion USD by Blackstone and loaded with 8.1 billion USD worth of debt.

Following the 2008 crisis, the ability for the DB pensions mentioned by David Merkel to monetise their investment was shut down because the IPO market went down by 70%. Endowments and pension funds which poured into private equity pools during the "credit" binge, did not receive the return they thought they would get on their investments.

So why DELL is looking at a LBO? It stock price fell 29% in 2012 due to increased competition from the likes of LENOVO.

DELL Share price 1 year evolution (18th of January 2012 to 17th of January 2013) - source Bloomberg:

DELL reported weak results in its Q3 with revenue below its prior guidance range (down 10.7% YoY) and EPS below expectations. DELL's is facing increasing headwinds in the PC space and has seen its business fall sharply in the third quarter in both consumer and commercial markets.

In this "deflationary environment" (falling prices) in the PC space, both DELL and HP have been losing market shares to Lenovo in both end-user segments. As we posited before, whether it is for the car industry, or the shipping industry, it is, end of the day, a game of survival of the fittest which entails serious strategic adaptations for some.

"Lenovo shipments gain 24% in industry beset by falling prices" - source Bloomberg

"PC shipments should increase while prices decline as value markets such as China and India grow to become larger portions of the market. Intel-branded Ultrabooks are spurring innovation in PC technology that appeals to mass-market buyers, and has been largely absent in recent years, apart from the laptop. Lenovo's shipments grew 24% in 2Q." - source Bloomberg

As reported by Bloomberg, Dell's "PC Competitiveness" is a much in focus as its financial metrics - DELL, HP and LENOVO, market shares evolution:

Although DELL has been losing PC Market Share, it has managed to increase its market share in the Global Server Market.

The Global Server Market Share was impacted by the macroeconomic weakness of 2012 which drove, according to Bloomberg a 4% YoY decline in 3Q server revenue. DELL was the only top five server vendor  to increase revenue, with 8% growth. HP saw its revenue in that space fall 12% while IBM declined 8% ahead of new products being introduced in the fourth quarter. Oracle fell 23% as it moves away from low-end servers - source Bloomberg:

While Dell's current 9 billion USD debt pile isn't insurmountable at 89% of total equity as of the end of 3Q, the serious threat posed by Lenovo warrants caution in relation to its future under a new owner via a LBO, because Lenovo has leapfrogged HP to become the top global notebook maker with 15.9% market share:
"The overall portable market fell 7%, led by declines at Hewlett-Packard (19%), Dell (18%) and Acer (7%). Apple grew 10% and Asustek 8%. Tablets and smartphones appear to be increasingly hurting portable sales." - source Bloomberg

"Dell's debt is 89% of total equity as of the end of 3Q, with a total of $9 billion on its balance sheet. With cash and equivalents of $11 billion and a trailing free cash flow of $3.1 billion during the last four quarters, this debt burden is not insurmountable, especially with low rates and an A- S&P credit quality rating." - source Bloomberg

From a pure deal point of view, we agree with Bloomberg in the sense that Dell's cash flow and valuation makes the private equity option looks rational - source Bloomberg:

"Dell's free cash flow generation of $3.1 billion, $2.2 billion net cash position and valuation metrics (7.6x ex-cash P/E and 6.9x price-to-free cash flow) may appeal to a buyer. Dell is discussing going private with TPG Capital and Silver Lake, Bloomberg News reported. An assumed 30% premium to Dell's Jan. 14 price would create the industry's first $28 billion deal, topping HP's $25 billion 2001 acquisition of Compaq." - source Bloomberg

But from a strategic point of view, it all depends on the strategic orientation DELL will embrace under its new ownership. The intensity in the competition for PC from the likes of Lenovo, makes it increasingly difficult for DELL to protect its own turf as PC have become more commoditised and are facing as well a change in consumer spending patterns with the increased developments of smartphones and tablets.

If DELL is to survive, even under a new "leveraged" ownership, it will have to adapt fast, given that across most of its product lines (storage, software, peripheral, mobility and desktop) have seen important declines as per their recent 3Q results (PC business declined 19% YoY with desktop down 8% YoY and mobility down 26% YoY).

For DELL, the only way is up, up the value chain that it is (entreprise solutions and services) for the LBO to increase its probability of success and to avoid being saddled by debt like its Texan neighbor Freescale Semiconductor Inc.

Moving back on the private equity deal flow and in relation to David Merkel astute comment, relating to pension funds allocation to private equity, a recent note by independent credit research house CreditSights entitled "LBO Risk Revisited for HG Bonds" from the 20th of January 2013 explains clearly the rationale behind private equity allocation:
"The correlation between strength in the high yield origination cycle and private equity deal volume is hardly a new one since the HY market exploded onto the scene in the 1980s. The problem with high yield origination booms is that they have had a habit of quite literally exploding as they did after the LBO binge of the mid-to-late 1980s and after the TMT cycle. In the LBO boom of 2005-2007, the end was also quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains. The reality is that a wide range of LBO deals are still in limbo from the 2006-2007 period and it will take more time to get those deals off the books via an IPO or strategic buyers. That does not prevent new funds from being set up by new investors or to see higher allocations from pension funds raising their commitments to private equity. These funds need to plan on meeting their return shortfalls in future years, and their allocations in high quality fixed income make for very difficult math." - source CreditSights

One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...).

As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks:
"So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."

For us, mega-LBOs, such as DELL, are another "smart way" in snaring in "yield starving investors" in the "credit mouse-trap".

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

Stay tuned!

Credit - The return of Cov-Lite loans and all that jazz...

Definition of Credit Market insanity:

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

Back in February 2011, we discussed the dangerous return of Cov-lite loans financing. Back In February 2011, during the Wharton School of Business annual restructuring conference, many panelists voiced their concerns on the return of the worst practices leading to the burst of the credit bubble, namely the return of many dangerous financing practices:

"The Distressed Hedge Fund Panel participants lamented the return of some of the worst practices such as HoldCo PIK dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses."

As a reminder from our 2011 conversation, we referred to what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, said in her article - Corporate Subprime - The default crisis that never happened:

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.

After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."

But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Old habits die hard:

"Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard and Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006."

According to Nicole Bullock from Financial Times on the 10th of May in her article - Cov-lite loans make post-crisis comeback:
"In April, companies obtained $7.6bn of cov-lite loans, equivalent to more than 40 per cent of so-called institutional loans extended to companies in the US, according to S and P Capital IQ LCD, a research group. That is the highest monthly proportion since May 2007.
Cov-lite loans extend credit to low-rated corporate borrowers, but strip out some of the traditional protection for lenders. That protection is financial covenants that trigger a default if a borrower’s financial health declines while it is still making agreed interest payments.

When the global financial crisis hit, it was feared cov-lite loans would lead to huge losses for investors. Those losses, though, have yet to materialise, opening the door to a revival of such deals during bouts of market strength."

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market.

Standard and Poors indicated in a LCD Daily Wrap-up from the 27th of April, such a resurgence of these bad financing habits coming back to play:

"Ineos’ new covenant-lite financing was in focus on the 27th of April after allocating late in the morning. The $2 billion, six-year term loan (L+525, 1.25% LIBOR floor) was pegged at 100.25/100.625, which is off the session’s highs but well above issuance at 98.5 and either side of par on the break. The $375 million, three-year tranche (L+425, 1.25% floor) that was targeted to older-vintage CLOs was also trading at a healthy premium to 99 issuance, rising to 100.25/101 by afternoon."

also on the 27th from the same LCD Daily:
"Schrader cov-lite loans allocate, break atop OIDs

Accounts today received allocations of the first- and second-lienfinancing backing Madison Dearborn’s acquisition of Schrader International. The $235 million, six-year first-lien term loan freed to trade at 98.5/99.5, from issuance at 98, sources said. It cleared the market at L+500, with a 1.25% LIBOR floor, and is covered by a 101, one-year soft call premium. At 98 issuance, the loan yields roughly 6.84% to maturity, which narrows to 6.62% at the midpoint of the bid/ask on the break.

The $100 million, seven-year second-lien term loan broke into a 98.75/99.75 market, from issuance at 97.5, sources added. The second-lien is priced at L+925, with a 1.25% floor; it carries 103, 102, 101 call premiums in years 1-3, respectively. It yields about 11.5% to maturity, or 11.09% at the midpoint of the bid/ask."

As reported, Barclays, Goldman Sachs, and Citi yesterday sweetened pricing on the deal as they stripped maintenance covenants from the term loans. The first-lien term loan launched to market with leverage and interest-coverage tests, while the second-lien originally included a leverage test.

Original price talk, meanwhile, was L+450-475, with a 1.25% floor and a 98.5 offer price on the fi rst-lien, and L+850-900, with a 1.25% LIBOR floor and a 98 offer price on the second-lien.

In addition to dropping covenants, the excess-cash-flow-sweep thresholds were been revised; the sweep starts at 50%, falling to 25% at 3.5x and to 0% when leverage is less than 3x. Previously, the respective step-downs occurred at 3.75x and 3x, sources said."

Corporate loans typically include provisions, or what we call covenants. They can trigger a "default" if finances deteriorate, even if the borrower is still paying interest. This forces the company to negotiate with the bank lenders, often allowing them to force a restructuring. Covenants also act as early warning system when the credit metrics of company start to deteriorate.

According to Moody's, as reported by Patricia Kuo and Katrina Nicholas in Bloomberg today - Europe Leveraged Loan Defaults May Rise to 25%, Moody’s Say:

"At least 25 percent of unrated European leveraged buyout companies with debt due by 2015 may default as the economy worsens and private-equity owners refuse to inject capital, according to Moody’s Investors Service.

An analysis of European LBO companies found that 254 had a combined 133 billion euros ($167 billion) of debt due by the end of 2015, with more than half owed by 36 borrowers, Moody’s said in a report.

“The 2014-2015 refinancing risk remains large and worrisome given our expectations of protracted macroeconomic weakness combined with the weak average credit quality of this universe,” analysts led by London-based Chetan Modi wrote in the report. “We do not expect that private equity sponsors will inject further capital into their own distressed companies

primarily to assist their lenders.”

From the same article:

"Some 125 billion euros of syndicated corporate loans are maturing before the end of 2013 in countries on Europe’s periphery, according to data compiled by Bloomberg. Companies in Asia outside of Japan have more than $110 billion of U.S. dollar-denominated loans maturing in the same period, the data show.

A similar risk of leveraged loan defaults doesn’t exist in Asia, according to Neil McDonald (Hong Kong-based head of law firm Hogan Lovells International LLP’s business restructuring and insolvency practice in Asia), who has advised commercial banks on their debt obligations to Dubai World and bondholders of Sino-Forest Corp. and China Forestry Holdings Co."

Standard and Poor's Leveraged Loan Index Description (Market Value Index Level) - source Bloomberg:

The Europe leverage loan price picture - source Bloomberg:

Looking at the above graph, we do think investors happened to  have been very lucky, once. Indeed, as any statistician would tell you, it was a good outcome for a bad risk. It doesn't mean a good outcome is going to happen again...

"You can't bank on the outcome."
Daniel Berrigan

Stay tuned!

Play it again Ben - The "dubious" return of Cov-lite financing and other leveraged plays...

While every one is focused on Oil's recent surge linked to the contagion of unrest in the Middle-East, Bahrein, Lybia and co, looks like crazy leverage credit is rearing its ugly face again.

Remember 2006 and the craze for LBOs financed with Cov-lite loans? Well guess what, the boys are back in town!

Albert Einstein Quotes - Insanity: doing the same thing over and over again and expecting different results...

Definition of Credit Market insanity:

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

Below is a link to what was discussed at the latest Wharton School of Business annual restructuring conference in February:

http://www.gurufocus.com/news.php?id=123115

"The overwhelming consensus among Panelists and Speakers was that we are experiencing a credit bubble and precipitous drop in risk premiums across asset classes, particularly in High Yield Bonds and Leveraged Loans."

"The consensus was that 6.7% was far to low a yield for HY bonds, even thought it is not an all times low on a spread basis, and that it did not portend well for those long HY at these prices."

Get ready for a bumpy ride ahead:

"The longer-term outlook gives cause for apprehension. Some of the concerns evidenced were: the large maturity wall between 2012 and 2015 which is currently comprised of debt trading well below par and unlikely to be refinanced; earnings going up against much tougher 2010 comps in 2011, large fiscal deficits and federal debt in the US combined with state and municipal debt; US bank balance sheets with large amounts of distressed and defaulted debt marked as hold-to-maturity with bid ask spreads so far apart that it is not getting worked off; regional banks sitting on commercial real estate loans that have been amended and extended that are likely to be the next shoe to drop in terms of debt restructurings; and European Sovereign Debt concerns along with skepticism regarding European bank balance sheets."

In respect to the US credit markets:
"With respect to the US credit markets, panel participants shared the view that we are nearing a top and that there will be a second distressed wave in the not so distant future."

Pre-flight "investor" safety briefings:

Keep your seat belt fastened
Before take-off and "hard" market landing ensure that your:
Seat belt is tightly fastened...
In the event of a crash landing, adopt the recommended brace position.
Place your hands on your head with your elbows on the outside of your thighs and your feet flat on the floor.

The panelists went on according to the same article:
"An interesting term was used for current state of bank amendments, “Amend and Pretend”, indicating that there is still an unwillingness on the part of banks to acknowledge certain problem credits."

One of the most important point of the article:

"The Distressed Hedge Fund Panel participants lamented the return of some of the worst practices such as HoldCo PIK dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses."

Yes, Cov-Lite deals are back. Lessons learned? Doesn't seem like it.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, had to say in her article - Corporate Subprime
The default crisis that never happened:

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.

After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."

But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Well, Bethany me too, I am also asking myself if they have gone insane again.

Looks like the street smart (Hedge Fund community...) attended the Wharton conference...

Gwen Robinson posted on the 5th of June 2007 the following article on Cov-lite loans:

Cov-lite loans: bubble-time or a sign of maturity?

Secondary spread of covenant-lite loans has narrowed dramatically:

The answer was bubble Gwen...

Bethany goes on in her article:

"This calculus shifted in 2006, because the financial world was awash in credit. Yields on debt were so low that investors were searching for something, anything, that paid just a little bit more. Subprime mortgages were one answer, but so were cov-lite loans made to highly indebted takeover targets, which paid just a wee bit more in interest (and at the peak of the mania, it really was just a wee bit) than super-safe debt. A big market for these loans existed in so-called "collateralized loan obligations," or CLOs, which were a sister of the "collateralized debt obligations," or CDOs, that snapped up subprime mortgages. Investors such as insurance companies bought slices of the CLOs, which were assigned varying levels of risk by the rating agencies, just as they bought slices of the CDOs.

Another reason for the rise in cov-lite loans was the relationship of mutual convenience between private equity firms and Wall Street banks. Private equity firms wanted cheap money on easy terms to finance all those big buyouts. Because private equity firms made such great clients—all those fees generated by buyouts!—Wall Street banks vied to give them what they wanted. Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard & Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006. Most of that came in 2006. In the first six months of 2007, cov-lite volume hit a stunning $97 billion, according to an S & P piece called "The Leveraging of America: Covenant-Lite Loan Structures Diminish Recovery Prospects."

Bethany adds:

"There are other similarities between the credit bubble and the current credit market. Banks still want to please their biggest clients, the private equity firms. And CLOs are once again a brisk market for whatever higher-yielding debt that can be found. That's because CLO managers aren't paid to have cash on hand, and all that refinancing of risky debt has resulted in an inflow of cash. They have to invest the money somewhere—and in order to justify the existence of the CLO in the first place, it has to be somewhere that offers a decent yield."

Some facts as per Bethany's great article:

"According to S&P, more than 25 percent of first-lien loans (those that have the first call on a company's assets) issued in 2011 have cov-lite structures. The $8.8 billion in such issuance so far this year already tops the total for all of last year, and it isn't even March. Among the private equity deals that used cov-lite loans are the buyouts of Del Monte and J. Crew, according to market participants."

And Bethany concludes:

"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with. You also might see in the desperate hunt for yield some uncomfortable parallels to the bubble years. Weren't we all supposed to have learned that too much debt is bad for us? Whether the cov-lite deals getting done right now will face a day of reckoning is anyone's guess. But at the very least, these deals strike me as a sign that some kind of reckoning is in store. I hope I'm wrong about that."

I hope too.
From the Standard & Poors website:

Full Index analysis: Loans return 10.13% in no-drama 2010

"If, on the other hand, the economic recovery fizzles for whatever reason – the known worries have been recounted in this space many times – loans would likely slip as risk-margins widen and the asset class loses its luster with retail investors, which poured a record $16.2 billion into prime funds in 2010, according to Lipper FMI, pumping up demand."

At the Wharton Restructuring conference, the panelists commented:

"One panelist noted the CityCenter refinancing at over 8x leveraged through the first liens and 12x through the seconds as one of the “worst deals ever done”, and a strong indication of an over-heated credit market. Another instrument highlighted as being fundamentally unsound are the surplus notes being issued by mono-lines, these are deeply subordinated securities that have little security and function more like preferred stock. They are being marketed to aggressive credit investors reaching for yield, a strategy that most agreed would end badly for those investors. Distressed investors were cautioned against style drift into chasing large-cap HY."

They went on:

"The Distressed Hedge Fund panelists identified the low quality refinancing being done over the last year as a strong source for potential distressed names over the next 18-24 months. Steve Moyer noted that between 2012 and 2016 there are $650bn dollars in maturities coming due, $150bn of which is Ca1 or below. Many of these issues are trading well below par and are unrefinanceable which will present opportunities for distressed investors. Moreover, Shawn Foley of Avenue Capital cited a JP Morgan report indicating that the majority of CCC rated paper has less than 1 turn of equity beneath it, a proposition he considered unsustainable."

Want a perfect storm?

"The primary concern among all conference participants for both credit instruments and the economy is the anticipation of a substantial increase in inflation. With PPI up almost 9% and CPI up only 3%, companies are suffering margin compression. Companies will be forced to raise prices which will eventually lead to wage increases to compensate for that higher price level. Commodity prices for cotton, wheat and corn are all near record highs while industrial commodities and oil have also moved higher signaling inflation in the pipeline. In addition, food price rises in non-producer countries in the third world are a major source of global instability and are large factor in the civil unrest in the Middle East. Mid-caps are particularly vulnerable due to a lack of pricing power and international diversification."

What about banks balance sheets?

"It was estimated that banks are still sitting on $2 trillion of mostly middle market loans that they have yet to take a write-down on. And while the Fed has pressured financial institutions to deal with their books with respect to residential housing, construction and building products, they have been far more lenient with respect to other sectors. That is particularly the case with commercial real estate, most of which is on the balance sheets of regional banks. When commercial real estate will start restructuring en masse was also a prime topic for discussion. The 2005-2007 vintage LBOs were considered to be the best class of candidates for restructuring opportunities now and in the future."

And finally the icing on the cake:

"The key take away from a distressed investor’s point of view, is that while there are currently some opportunities in less liquid middle market names, the overall HY and leverage loan markets are experiencing a 2005-2007 type bubble."

Good night and good luck: