Junkyard blues

As the high-yield bond market shrinks, corporate and private equity borrowers are turning to bank loans. That could spell trouble for them later.

When private equity giants Texas Pacific Group and Warburg Pincus struck a $5.1 billion deal to aquire Neiman Marcus Group in May, they planned to sell $2.2 billion in non-investment-grade bonds to help finance the leveraged buyout. By September, when they needed the cash to close the deal, the market for junk bonds had turned sour. Spooked by rising interest rates and concerns about default risk, investors grew less hungry for the luxury retailer’s bonds, which are rated B by Standard & Poor’s.

Junk bonds have traditionally provided a lot of the leverage in LBOs. But weakness in that market didn’t derail the Neiman deal. Lead underwriter Credit Suisse First Boston slashed the bond sale to $1.2 billion and turned to the increasingly liquid institutional loan market for the bulk of the financing -- an additional $2 billion. Indeed, Neiman received outstanding terms on the loan, including a waiver of customary covenants requiring that debt not exceed a set ratio to cash flow.

Many other borrowers are taking a similar route, whether as part of a leveraged buyout or not. Through early November corporations had issued just $80.8 billion of high-yield bonds in 2005, putting the year on pace to trail 2004’s $141.9 billion by 32 percent, according to Thomson Financial. Underwriters shelved several deals in October, including those for Houston-based energy company Targa Resources and Milwaukee-based Roundy’s Supermarkets.

Several factors have dampened interest in new issues, most notably the Federal Reserve Board’s 12 consecutive hikes in the overnight lending rate since June 2004. Springtime downgrades of bond market stalwarts General Motors Corp. and Ford Motor Co. to junk status not only boosted the supply of high-yield paper but also sent a warning to investors that defaults could rise. More than $10 billion has flowed out of high-yield mutual funds this year, according to research firm AMG.

Junk bond woes have meant joy for the leveraged-loan market. Unlike most bonds, loans pay interest that floats as market rates change, making them more attractive to investors as rates rise. And bank loan owners have the most senior claim on a company’s assets in the event of a default, whereas bonds are subordinate in the capital structure.


“Secured bank debt does well through higher default environments,” says Thomas Newberry, global head of the syndicated loan group at CSFB.

Another boon is intense interest among investors, especially hedge funds, in collateralized loan obligations -- vehicles that package portfolios of high-risk bank debt. The demand for CLOs is making capital cheaper for borrowers. The average spread for loans rated BB/BB in October was just 170 basis points above LIBOR, according to S&P. Similarly rated bonds can cost issuers 250 basis points more.

To be sure, this could prove to be a short-term phenomenon. “Interest rates tend to be cyclical, and it’s reasonable to assume that the shoe will be on the other foot at some point,” says Martin Fridson, CEO of research firm Fridson Vision and a veteran high-yield bond analyst.

But the move toward loans as a substitute for junk bonds could lead to trouble. Most loans mature in five or six years (compared with up to ten for corporate bonds), carry restrictive covenants and require borrowers to pledge collateral. Companies that rely heavily on loans and run into trouble thus will face more frequent negotiations with more powerful creditors. And the emergence of hedge funds and other institutions as lenders may complicate bankruptcy reorganizations.

Buyout firms may also suffer. They’ll be less able to sell bonds to further leverage existing portfolio companies, as they have done to fuel their immense profits in recent years (Institutional Investor, May 2004). LBO firms may also have to invest more equity in acquisitions or pay higher interest on debt, which could depress returns. The rush into the loan market, then, may be a case of borrowing now but paying later.