Corporate Credit Risk

Readers of this blog will be aware that there are not many exciting posts of late. Well, its because I am still bearish and still awaiting for the credit bubble implosion to play itself out. We have the European banks turn, and then the AAA rating for certain insurers in jeopardy, and now the corporate bonds - more specifically the leveraged buyout bonds market.

WSJ - A new problem is rippling through credit markets: Many of the corporate loans used to finance giant buyouts in the past few years are reeling in secondary market trading, making it virtually impossible for banks to unload other commitments they have made. The loans of First Data Corp., which was taken private in September by Kohlberg Kravis Roberts & Co. for about US$28 billion, were sold into the market this past fall at a 4% discount to their par value; they now trade in the market at a steep 11.5% discount to par value. Loans of Freescale Semiconductor Inc., taken private by a consortium of private-equity firms in December 2006 for about US$28 billion, are trading at a 15.5% discount to their original value; Tribune Co., which was taken private in April by investor Sam Zell for US$8.2 billion, issued loans now trading a 26% discount.

The loans are known by investors as "leveraged loans," used by companies often with low credit ratings to raise money, often for buyouts. They are issued by banks and sold to investors like junk bonds, though leveraged loans tend to be safer because their investors get paid off in a bankruptcy before junk-bond investors. Double-digit declines in the market value of these loans are very unusual, and a big problem for many banks, which sit on a pipeline of US$152 billion in loans that they have promised to make but have yet to sell to investors. With the prices of existing loans tumbling, investors have little incentive to buy new loans unless they are sold at steep discounts, something banks are reluctant to do.

The result: More assets building up on bank balance sheets, growing tensions among rival bankers who had grown accustomed during the buyout boom to cooperating with each other and a deepening crisis in the market for buyout debt. The crisis started last summer, when investors turned up their noses at billions of dollars in buyout debt, just after many buyout firms and their bankers made commitments to history-making megadeals. Many investors say January was the worst performance for this market since those summer months.

Finance professor Edward Altman projects that high-yield, or "junk," bonds will default by a rate of 4.64% this year. That would be the highest rate since 2003 and a nine-fold increase from the 0.51% rate in 2007, which was the lowest rate since 1981. High-yield debt is typically used by lower credit-quality companies to fund operations and acquisitions.

Mr. Altman, whose so-called Altman-Z score is the market standard for predicting bankruptcy, sees as much as US$53 billion in high-yield debt defaulting in 2008, up from US$5.5 billion in 2007. Mr. Altman's study takes into account a company's original credit rating when it received its financing, historic default rates, the size of debts outstanding, and other factors.

Already in January, Mr. Altman estimated defaults hit US$3.2 billion, about 60% of the total for all of 2007. New high-yield issues totaled a near-record of US$141 billion in 2007, but almost US$100 billion of that was in the first six months of the year before the credit market slowdown took fuller hold. In a recent Federal Reserve survey of senior bank-loan officers, one-third of U.S. banks and two-thirds of foreign banks said they had tightened lending on commercial and industrial loans. Half the banks said they widened the spread between their cost of funds and what they charge corporate borrowers.

Besides the tight credit market, bond defaults could also be driven up by the large amount of high-yield debt coming due. As companies look to roll over this debt, they will either have to pay higher interest rates or will be shut out entirely by lenders. Mr. Altman estimates about US$160 billion in leveraged loans and about US$30 billion in high-yield bonds will come due this year, a similar amount in 2009, followed by even more between 2010 and 2013.

Comment - The pricing is quite bad and these kind of pricings usually indicate that the companies are near bankruptcies, but in reality they are not. Is this a mis-pricing, maybe... maybe the market has overpriced the level of risk into these type of leveraged deals. Leveraged deals require a swift improvement in margins and good revenue growth to be worthwhile for all those invested in these deals. The risk which is being priced in probably took into account a slowing economy, which would severely hamper revenue growth plans. Hence even with strong gains in margins, it might not be sufficient to compensate for the slowdown effect. The unexpected slowdown, and a tighter credit refinancing market would be a near term and mid term obstacle for many of these leveraged buyout deals. Even with rates being reduced, lenders seem to be unwilling to lend at the reduced rates now and in the near future - this is partly why I regarded the rate cuts by the Fed to be not a cure-all for a credit bubble implosion. Yes, you reduced the rates but the lenders are not willing to lend at the new rates, or even higher rates. This will have a snowballing effect. Unfortunately, we will have to go through more volatility and probably downside before things get better.