June 28 (Bloomberg) -- Cracks are starting to appear in the credit market, threatening to disrupt the flow of easy money that has fueled a record pace of leveraged buyouts. No wonder Blackstone Group LP is trading below last week's initial public offering price.

ServiceMaster Co., which owns pest-control and gardening companies, is the quarry in a $5.2 billion buyout by Clayton Dubilier & Rice Inc. The company failed to find buyers for $1.15 billion of a bond flavor called pay-in-kind toggle notes this week, intended to fund the takeover.

Instead, Downers Grove, Illinois-based ServiceMaster will split the sale between ordinary debt and toggle notes, which give it the right to hand investors more debt instead of interest payments.

US Foodservice, a unit of Royal Ahold NV, the Dutch supermarket chain being bought by Clayton Dubilier and Kohlberg Kravis Roberts & Co., took three stabs at sweetening the terms of its planned $1.55 billion fund raising before junking the deal. Toggle notes again proved unpalatable to investors.

Also this week, KKR boosted the interest payable on a $2.43 billion loan funding its purchase of discount retailer Dollar General Corp., investors who may buy the debt told Bloomberg reporter Harris Rubinroit. Instead of as little as 2.5 percentage points more than money-market rates, the loan will pay a premium of 3 percentage points, boosting the potential quarterly interest payment to as high as 8.36 percent.

And Thomson Learning, a unit of Thomson Corp., scrapped the riskiest slice of a planned $2.14 billion bond sale last week. It boosted the interest it was willing to pay on its loans and cut the amount of debt offered to $1.6 billion to get the sale away.

Making Demands

The corporate-bond market has been transformed in recent years, from an arena where publicly traded companies raise cash to a pool of capital tapped by private-equity firms to finance their acquisitions. And as investors start to demand more juice to finance takeovers, even higher-rated borrowers are beginning to struggle.

Arcelor Mittal, the world's biggest steelmaker, abandoned plans to sell five- and 10-year bonds in euros this week. Bankers for the company cited the aftershocks rippling through global debt securities from the turbulence in the U.S. subprime mortgage market. So much for containment preventing contagion.

Some savvy corporate treasurers who scented the change in the borrowing environment got going while the going was good. Before the Arcelor cancellation, Europe was having its busiest month this year for new debt sales, with companies such as Enel SpA, Italy's biggest utility, and BT Group Plc, the biggest U.K. telephone company, borrowing more than $25 billion.

Record Year

Buyout firms have announced more than $530 billion of acquisitions this year, putting them on course to top last year's record $701.5 billion and maybe reach $1 trillion for 2007. Cheap finance from the debt market has nourished that growth.

If that easy money stops flowing, though, companies such as Blackstone, which raised $4.13 billion last week in the biggest U.S. IPO in five years, will struggle to make as much money. The shares were sold at $31 each on June 21; they traded as low as $29.13 this week.

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The Bank of Japan is itching to raise interest rates, which would tweak the noses of speculators using cheap yen to fund their carry trades. Deflation, though, is proving to be a stubborn obstacle to the central bank's policy intentions.

Core consumer prices, which exclude fresh food, probably fell 0.1 percent in May from a year earlier, according to the median estimate of 45 economists in a Bloomberg News survey. That would match April's drop, extending a streak of falling prices every month this year. The report is due tomorrow.

Bank of Japan Governor Toshihiko Fukui may have to make good on a threat he made last month, saying the central bank could raise interest rates even without an accompanying increase in core prices provided policy makers were confident that deflation was almost at an end.

The bank can take comfort from figures yesterday showing Japan's retail sales unexpectedly rose for the first time in eight months, climbing 0.1 percent in May from a year earlier. Moreover, economists expect tomorrow's inflation reports to show the first increase in core prices in Tokyo in five months. That might be the ammunition the central bank needs to lift its benchmark rate from 0.5 percent in the third quarter.

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Stock-market volatility is climbing. The Chicago Board Options Exchange Volatility Index, known as the VIX index, reached its highest level since February this week, rising to almost 19 from less than 13 last week.

``The February spike was temporary,'' wrote Stuart Thomson, who manages 23 billion pounds ($46 billion) at Resolution Investment Management Ltd. in Glasgow, Scotland, in a research note. ``The current period is likely to be more lasting.''

The index averaged 11 in the final quarter of 2006, less than 13 in the first quarter of this year, and is up to a mean of 13.65 this quarter. Volatility declined in the first half of the decade; the 2002 average was more than 28, waning to 22 in 2003, less than 16 in 2004 and below 13 in 2005. As central banks around the world battle faster inflation with higher borrowing costs, there's scope for volatility to increase.

``As interest rates are tightened globally, the coordinated actions of central banks are more reminiscent of 2003 than 2004, suggesting that there is potential for financial market volatility to rise further over the summer,'' Thomson wrote.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net

Last Updated: June 27, 2007 19:34 EDT