Beyond interest rate risk, when purchasing a corporate bond, investors tend to most fear two primary risks: a default, or an adverse corporate action, such as a leveraged buy-out (LBO). Since the crisis of 2008/2009, we have seen a sharp drop in the number of US dollar-denominated corporate bond defaults, returning to levels only slightly higher than those in the relatively quiescent mid-1990s.
While the overall economy continues to slowly recover, the cash balances and overall creditworthiness of corporate borrowers has increased dramatically. Effectively, after the events of 2008, many corporations “got religion” by insuring the liquidity and stability of their balance sheets.
As a result, the primary risk for corporate issues has shifted from default risk back to the risk of adverse corporate actions. In the calm market period that preceded the crisis, there were many corporations that underwent public-to-private LBO’s, whereby a financial buyer would purchase a business through a highly leveraged transaction. In effect, the management exercised their capital structure option to the detriment of existing bondholders. While the effects of these moves were not as dramatic as a complete default, holders of the company’s debt often saw very significant price impairments.
Today, the corporate bond market is relatively stable, with a strong bid for new issuance. Additionally, because of extremely low Treasury yields, the all-in absolute yields on corporate bonds are approaching lows not seen in decades. As a result, there has been a lot of discussion regarding the risk of a new LBO wave, including compiling lists of the “usual suspects” of LBO candidates to avoid.
However, we feel that this risk is misplaced given the relative costs faced by potential buyers. Instead, the far greater risk is from potential strategic buyers.
Why Strategic Purchases Are More Likely than LBOs
With Treasury yields near historically low levels, funding is generally cheaper across the board for all potential purchasers. However, high quality issuers of debt command a significant cost advantage over a potential LBO-funded bid. Unlike the 2006 to early 2007 period, for example, the spread demanded to fund an LBO in the bank debt market is significantly higher than the yield spread required for a strategic purchase. The market appears to have bifurcated between the “have’s” and “have not’s.” Higher quality issuers enjoy an almost unlimited demand for their paper at remarkably low all-in yield levels. On the other hand, the yield premium demanded to loan to highly leveraged bank deals, relative to investment grade credits, is still above pre-crisis levels.
Additionally, after the crisis, many potential purchasers have accumulated significant cash positions on their balance sheet. While managements of some corporations have chosen to distribute this money through dividends or share repurchases, there have also been a significant number of traditional merger and acquisition (M&A) purchases. In fact, as a percentage of total transactions, traditional M&A has gained significant share relative to LBO purchases. In effect, the strategic buyer generally has a better bid for assets than leveraged investors in the context of today’s funding climate.
The investment implications are clear: while a strategic purchase of another company often leads to increased leverage at the acquirer, the level of additional debt pales in comparison to that typically required for an LBO purchase. As a result, the spread widening that an investor is risking for a strategic purchase is smaller than would otherwise be the case with a more leveraged buyout. In fact, we have recently witnessed several “LBO candidates” enter into strategic transactions. These companies, such as Sealed Air Corporation or Ashland Inc., saw their yield spreads widen on the news, but the effects were far more muted than would have been the case had there been an LBO. Therefore, any yield premium demanded by the market for being an “LBO candidate” may very well be too high. Additionally, unlike in an LBO, a strategic transaction involves both an acquirer, whose yield spread widens, and a target company.
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