How long will the credit window stay closed to corporate debt? More than $90 billion in high-yield corporate bonds are waiting to get syndicated from banks to institutional investors, the by-product of a long boom in leveraged buyouts. That record six-month inventory of loans is about twice the typical backlog, corporate finance experts say. The problem? No buyers.
The debt financing window, which was wide open for the last three years, slammed shut this month because of the creeping credit squeeze that began with rumbles from the subprime mortgage market and has spread into higher grades of debt. Fears about tightened credit standards—and their effect on economic growth—arrived on Wall Street July 26 and 27, sending the Dow Jones industrial average down more than 500 points (5.4%) and the Standard & Poor's 500-stock index off nearly 5% in two sessions (see BusinessWeek.com, 7/27/07, "Let the Blame Begin").
Only four high-yield debt offerings have been priced in the week of July 20-27, according to Wes Sparks, head of U.S. credit strategy at Schroder Investment Management, which manages $260 billion in global assets: a $325 million offering for DAE Aviation Holdings, a $150 million offering for Parallel Petroleum (PLLL), a $225 million offering for True Move, and a $1.26 billion offering for InterGen NV. They had yields in the 9% to 11% range, a bit higher than they would have been priced several months ago. (Schroder didn't buy any of the debt, Sparks says.) The market for leveraged corporate loans, with a backlog of $200 billion, is all but closed as well.
The lack of new credit stems from a daily drop in prices in the secondary market, Sparks says. Investors aren't willing to buy something that's likely to be cheaper the next day. Another investor agreed. "Anybody who has bought credit recently has seen it trade down, so people are reluctant to try and catch the falling knife," says Dean Kehler, founder and managing partner at Trimaran Capital Advisors. "The way it feels now, if you wait it's going to be cheaper tomorrow."
Sparks said he thinks new debt will start to flow again within the next four weeks because of the sheer pressure created by the enormous inventory. "I expect sometime in August the market will stabilize, probably with higher yields and better covenant protections and fewer poor debt structures."
The consensus estimate is that credit markets will remain virtually closed well into the fall, if not until early next year. One credit investor says that forecast is reasonable, but that if the economy takes a turn for the worse and default rates rise from the current historic low level, the shakeout could take far longer. "We're really looking at serious trouble if the economy goes bad and default rates rise," says Steve Smith, joint global head of leveraged finance at UBS (UBS).
Right now, the problems in the credit market are technical issues of supply and demand, says Smith. The market for pools of debt known as collateralized loan obligations has all but dried up, removing $50 billion in quarterly demand for securities. If the concerns about credit become broader—and include fundamental questions about credit quality—the problems will be deeper and take longer to solve, Smith says. And there are plenty of highly leveraged buyouts that could face pressure in a weak economy (see BusinessWeek.com, 5/29/07, "Private Equity's Big Debt Burden").
When the market finally settles down, it will look very different than the credit market of just last month (see BusinessWeek.com, 7/10/07, "End of the Private Equity Party?"). Interest rates for high-quality LBOs have been 1.75 to 2 percentage points above the London interbank offered rate, or LIBOR, which currently stands at 5.26%, according to traders. The market for high-yield debt is only a bit more expensive. It is currently 3 or 4 percentage points above the rate for U.S. 10-year treasuries, which now yield 4.78%. High-yield debt will rise a percentage point, if not more, as the spread between high-yield and investment-grade debt widens, they say.
A few months ago, it often looked as if the LBO boom would never end. Now it's hard to imagine that risk-laden environment returning anytime soon.