Buyout Bets Wane as Swaps Show Economy Keeps LBOs in Check: Credit Markets
Buyout speculation that sent credit derivatives on companies from Cardinal Health Inc. to Dell Inc. soaring two months ago is waning as rising unemployment keeps the takeover revival in check.
The average cost of credit-default swaps on 15 companies including the Dublin, Ohio-based drug distributor and the computer maker founded by Michael Dell has declined 38 basis points to 143 basis points since Oct. 25, compared with a drop of 4.9 for a benchmark swaps index. Contracts on Cardinal Health have plunged to 58 basis points from 148 on Oct. 25.
Bets on a surge in leveraged buyouts are diminishing as the sluggish recovery limits private-equity and bank deals. While the LBO pace has more than tripled to $133 billion this year from 2009, a record $1.6 trillion of deals were announced from 2005 to 2007, according to data compiled by Bloomberg. Acquirers have to put up more equity, and the amount of debt that targets take on relative to earnings is less than during the buyout boom four years ago.
“Credit spreads are pricing very high chances of LBOs, yet the feared LBO boom has yet to ignite,” said Alberto Gallo, a credit strategist at Goldman Sachs Group Inc. in New York, who last month recommended investors sell protection on companies with credit swaps that jumped on the speculation. “We are in an environment where growth is accelerating, but remains at a low level. Leverage is scarce and expensive.”
Seagate Talks Collapse
Seagate Technology Plc, the world’s largest maker of disk drives, said last month it ended talks with private-equity firms for a leveraged buyout and instead authorized the repurchase of as much as $2 billion of its stock. Talks collapsed with buyout firm TPG Capital after the suitor wasn’t able to find other partners to raise enough equity financing, a person familiar with the matter said last month.
Private equity firms are typically borrowing 4.7 times the company’s earnings before interest, taxes, depreciation and amortization costs, compared with 5.5 times earnings in 2006, according to Goldman Sachs analysts.
Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar-maturity government debt fell 1 basis point to 175 basis points, or 1.75 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. Spreads reached a 12-week high of 177 basis points on Nov. 30. Yields averaged 3.76 percent yesterday.
Corporate bonds worldwide have returned 0.59 percent this month, bringing this year’s gain to 5.6 percent, according to the Barclays Capital Global Aggregate Corporate Index.
Merck & Co., the second-largest U.S. drugmaker, may sell as much as $2.5 billion of senior unsecured bonds today as yields on U.S. investment-grade company debt hover below 4 percent. Standard & Poor’s expects the Whitehouse Station, New Jersey- based drugmaker’s offering “to not significantly exceed $2.5 billion,” the ratings company said today in a statement. Moody’s Investors Service said Merck may offer $2 billion of senior unsecured notes.
The global speculative-grade default rate fell to a two- year low of 3.3 percent last month at Moody’s, as junk-rated borrowers tapped the bond market at a record pace. The rate declined from 3.7 percent in October and 13.6 percent a year ago, Moody’s said in a report today. Defaults will fall to 2.9 percent by year-end and 1.8 percent by November 2011, according to the report. That compares with a forecast last month of 2.8 percent by year-end and 1.9 percent by October 2011.
The cost of protecting U.S. corporate bonds from default fell for a fifth day, reaching the lowest since Nov. 8.
Default Swaps Fall
The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, decreased 2.2 basis points to a mid-price of 88.5 basis points as of 12:16 p.m. in New York, according to index administrator Markit Group Ltd.
The index has declined from 99.4 basis points on Nov. 30 amid speculation that European Central Bank policy makers will ramp up measures to contain the region’s sovereign debt crisis and following comments Federal Reserve Chairman Ben S. Bernanke made on CBS Corp.’s “60 Minutes” program on Dec. 5. The unemployment rate last month was 9.8 percent, the highest level since April, the Labor Department said on Dec. 3.
“We’re not very far from the level where the economy is not self-sustaining,” Bernanke said in the CBS interview. “It’s very close to the border. It takes about 2.5 percent growth just to keep unemployment stable and that’s about what we’re getting.”
The Fed Chairman indicated U.S. unemployment may take five years to fall to a normal level and Fed purchases of government debt beyond the $600 billion announced are “possible.”
Contracts on Cardinal Health more than doubled over six days from 59.8 basis points on Oct. 14 on speculation it could be acquired by private-equity firms. The swaps reversed after the company said Oct. 26 that it wasn’t in talks.
McKesson Corp.’s credit swaps have dropped to 48 basis points from as high as 96.6 on Oct. 25 as speculation cooled that the San Francisco-based drug distributor, which has a stock market value of $16.8 billion, could be acquired in a debt- fueled takeover. McKesson spokeswoman Ana Schrank declined to comment.
Contracts on Round Rock, Texas-based Dell jumped to as high as 129 basis points on Oct. 29 from 86 basis points on June 2, the day before its chief executive officer said he’s considered taking the company private. Swaps on Dell, which has a market capitalization of more than $26 billion, have dropped back to 98 basis points.
Credit-default swaps typically fall as investor confidence improves and rise as it deteriorates. Contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.
The swaps rise if a company is deemed a buyout risk because the debt added to its balance sheet to fund the takeover erodes its credit quality and leads to ratings downgrades. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Large jumps in swaps are typically unwarranted for companies with an enterprise value -- the sum of its stock and debt minus cash -- of more than $15 billion, said Nicholas Pappas, co-head of flow credit trading in the Americas at Deutsche Bank AG in New York. Companies that large, he said, are more likely to pursue mergers or acquisitions or buy back shares.
The number of acquirers teaming up on a bid has shrunk, according to Pappas. “We are not seeing five sponsors in one deal as we did in the past,” he said.
No ‘Big Credit Event’
Buyouts “haven’t been a big credit event for portfolio managers as of yet,” said Rizwan Hussain, a credit strategist at Morgan Stanley in New York. “You should expect to see more in 2011, but it doesn’t seem to me you could have particularly aggressive leveraged events.”
Bank of America strategists are still recommending investors buy protection on potential buyout targets with market values of $10 billion to $20 billion whose swaps are cheap relative to the rest of the market.
Contracts on a company that’s acquired in a leveraged buyout can jump 300 basis points, Hans Mikkelsen, an analyst at the bank in New York said in an interview yesterday.
“The conditions are still there for LBOs, so it’s just a matter of time,” Mikkelsen said. “The market will tend to run with any kind of speculation that comes up because the downside is so big.”
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