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Tuesday, 23rd April 2024
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Party is over as absolutely nothing is moving Back  
With two large debt offerings from private equity-backed Chrysler in the US and Alliance Boots in the UK both facing difficulties, William Gross, America's 'most prominent bond investor' argues that a growing lack of confidence has frozen future lending and backed up the market for high yield new issues such that, 'it resembles a constipated owl: absolutely nothing is moving'.
‘The sudden liquidity crisis in the high yield debt market is just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the U.S. economy. The fact is that several weeks ago, Moody’s and Standard & Poor’s finally got it into gear, downgrading hundreds of sub-prime issues and threatening more to come. ‘Isolationists’ would wonder what that has to do with the corporate debt market. Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in sub-prime housing space, they claim. Unfortunately that does not appear to be the case.

As Tim Bond of Barclays Capital put it so well a few weeks ago, ‘it is the excess leverage of the lenders not the borrowers which is the source of systemic problems’. Low policy rates in many countries and narrow credit spreads have encouraged levered structures bought in the hundreds of millions by lenders, in an effort to maximise returns with what they thought were relatively riskless loans. Those were the ABS CDOs, CLOs, and levered CDO structures that the rating services assigned investment grade ratings to, which then were sold with enticing LIBOR + 100, 200, 300 or more types of yields. The bloom came off the rose and the worm started to turn, however, when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space. Could the same thing happen to levered structures with pure corporate credit backing?

To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating sub-prime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.

Bond managers should applaud. It is they, after all, who have resembled passive owls for years if not decades. …the Blackstones, the KKRs, and the hedge funds of recent years also climbed to the top of the pile on the willing backs of fixed income lenders too meek and too passive to ask for a part of the action. Covenant-lite deals and low yields were accepted by money managers as if they were prisoners in an isolation ward looking forward to their daily gruel passed unemotionally three times a day through the cellblock window.

Well the caloric content of the gruel in recent years has been barely life supporting and unhealthy to boot – sprinkled with calls and PIKS and options that allowed borrowers to lever and transfer assets at will. As for the calories, high yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5 per cent), multiplying that by loss of principal in bankruptcy (60 per cent), and coming up with an expected loss of 3 per cent over the life of future loans. At LIBOR + 250 in other words, high yield lenders were giving away money!
Over the past few weeks much of that has changed. The mistrust of rating service ratings, the constipation of the new issue market and the liquidity to hedge the obvious in CDX markets has led to current high yield CDX spreads of 400 basis points or more and bank loan spreads of nearly 300.

But the tide appears to be going out for levered equity financiers and in for the passive owl money managers of the debt market. And because it has been a Nova Scotia tide, rising in increments of ten in a matter of hours, it promises to have severe ramifications for those caught in its wake.
No longer will double-digit LBO returns be supported by cheap financing and shameless covenants. No longer therefore will stocks be supported so effortlessly by the double-barreled impact of LBOs and company buybacks. The U.S. economy in turn will not benefit from this tidal shift and increasing cost of financing. The Fed tightens credit by raising short-term rates but rarely, if ever, have they raised yields by 150 basis points in a month and a half’s time as has occurred in the high yield market.

High yield lenders, perhaps if only in their frozen, frightened passivity, are signifying that the wealth must be redistributed, that the onerous oppressive tax in the form of low yields must change, and that finally enough is enough!

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