The Rush to Refinance Corporate Debt

Ka-ching. That's the sound of cash flowing into U.S. companies amid a deluge of new debt offerings this year, now on pace to surpass last year's total. As of Sept. 23, $666.44 billion of investment-grade and high-yield debt had been issued year-to-date, compared with $503.78 billion in the first nine months of 2008 and $673 billion for all of last year, according to data released by Dealogic on Sept. 24.

This may come as a surprise a mere six months after the height of the worst liquidity crisis in the history of global capital markets. But consider this: Whereas the proceeds from past debt issuance went toward general corporate purposes and long-term growth initiatives, 80% of these proceeds will be used to take out or substantially pay down debt that's slated to mature over the next few years.

Announcements of new debt issuance are now "often accompanied by the announcement for a tender [offer to existing debt holders] for outstanding debt at a pace I have never seen in past years," says Tom Murphy, manager of the RiverSource Diversified Bond Fund (RDBIX). He sees the breakneck pace at which new bonds are being issued in order to retire near-term maturities as a sign that corporate managers are worried the credit markets may tighten up again. It also tells him they're less optimistic about the prospects for economic recovery than are most economists and bulls—and are girding themselves for the possibility of further pain ahead.

"Corporate America…went through a near-death experience," he says. "There were literally days and weeks in the fall [of 2008] and spring where the highest-quality companies didn't have access to refinancing commercial paper or bank debt. A lot of them have vowed they don't want to be in that situation again."

Near-Term Debt: More Than $1 Trillion Other bond managers, however, view the issuance of new debt as a wise move in recognition of how low total borrowing costs are. "Smart companies are out there securing financing when they can, just to remove any risk that they'll be forced into default by a liquidity or maturity issue," says Michael McGonigle, director of investment-grade research at T. Rowe Price Group (TROW) in Baltimore. Other companies, however, are just fighting to survive, "trying to delay the day of potential Armageddon" by pushing out maturities and loosening debt covenants, he adds.

According to a report published in May by the Standard & Poor's Global Fixed Income Research team on the rising costs of issuing all but the highest-rated bonds, $394.7 billion in investment-grade corporate bonds matures in 2010 and another $412.6 billion in 2011, while $162.9 billion of speculative-grade debt must be repaid in 2010 and $265.7 billion in 2011.

A new white paper published on Sept. 24 by Ramirez & Co., a New York-based investment bank, shows that U.S. companies should reduce the debt on their balance sheets by an average 15% to 20% given the shocks to the marketplace, including the decline in production and earnings growth, the rise in unemployment, and the drop in stock prices.

The credit markets look far healthier than they did when S&P released its May report on issuance costs. That bodes well for debt-service costs, which should be coming down as a result of lower coupon rates. Currently the yield for investment-grade debt, as shown by the U.S. Barclays Corporate Investment Grade Index, is 4.94%, roughly 1.5% below the average yield of 6.37% over the past 16 years, says Murphy at RiverSource.

For the most part, companies with debt ratings of BB or below have to issue bonds in the high-yield market, where borrowing costs are much lower than a few months ago because of the dramatic drop in yields. Coupon rates on BB- and B-rated paper are 8% to 10%, vs. 15% to 20% earlier this year.

High-Yield Bonds: The "Natural Avenue" More important than the lower yields is that the debt market has reopened, allowing companies to push out maturities and providing relief from debt covenants that were much more strict under the bank loans they had, says Manny Labrinos, a corporate bond portfolio manager at Nuveen Asset Management in Chicago.

Unlike term debt, the bank loan market has not reopened much compared with where it was a couple of years ago. That's largely because vehicles for investing in collateralized loan obligations, or CLOs, which once bought more than 50% of the loan receivables packaged by banks, have disappeared. That dims the chances of refinancing bank loans and makes the high-yield bond market the "natural avenue" for issuing debt right now, says Labrinos.

The main reason for declining yields is the flood of money into credit markets, which need to put it to work, driving bond prices up and coupon rates down, says Labrinos. It comes down to huge demand for corporate bonds by mutual fund investors, amid a somewhat limited supply. Investors look at the more than 50% rally in equities since the March lows and figure there's no more than 5% to 10% upside left, while corporate bonds still have a fairly decent upside potential and a cushion on the downside provided by 8% to 10% yields in high-yield bonds, he says.

As with equities, the sectors whose bond prices have appreciated most have been the riskier ones. Bond prices in more defensive industries such as utilities, aerospace, capital goods, and health care—which didn't get hammered as much to begin with—have lagged the overall market, says Labrinos. Year-to-date returns as of Sept. 22, as measured by the Citigroup High Yield Market Index, were 65% for gaming sector bonds and 64% for auto and vehicle-parts manufacturers, he says. Returns in the auto sector include General Motors until its restructuring in June and Ford Motor (F), but not Chrysler, which wasn't in the index at the start of 2009 because it had only loans and no bonds outstanding.

Now Issuing: "Bullet Maturity Bonds" Even where companies are having to pay higher total borrowing costs, it's a net positive if, as a result of issuing new bonds, a company is able to push its debt maturity schedule far enough ahead to allow its cash flow to recover, says McGonigle at T. Rowe Price. These are typically high-yield bonds that a company will issue to pay off a bank loan with a much shorter amortization schedule, which depletes the company's cash flow by requiring that a certain portion of the loan—say 20%—be paid off each year until maturity.

"With reduced cash flows, they don't have the resources to meet that maturity ladder," says McGonigle. "So they're issuing bullet maturity bonds [so-called because they come due all at once with no annual paydown obligations] that mature in 5 or 10 years. That provides a longer runway cyclically to allow them to recover their cash flows."

Some investors are being more defensive by lending to companies for only 2 to 2½ years out because they want to ensure that they get paid back ahead of any big maturity that looms. Shorter-term bonds, however, don't provide much time for a company to recover sufficiently to be able to pay off all its debt, McGonigle says. Some companies are replacing bank loans that carried floating interest rates of Libor plus 2.6% to 4% with term bonds paying fixed coupons in the 8%-to-10% range, he adds.

Well Fargo's $2 Billion Issue When it comes to companies that still face material risks, investors are demanding seniority in the capital structure—either second- or first-lien debt that gets repaid ahead of other types of debt. But the market is still trying to impose pretty tough covenants to ensure that senior positions aren't compromised, says McGonigle.

Among recent higher-yielding issues are insurance provider Unum Group's (UNM) $350 million offering of 7-year bonds with a 7.125% coupon at a spread of 4.17% over comparable Treasuries, announced Sept. 25, and Wells Fargo's (WFC) $2 billion offering of 5-year bonds with an unknown coupon but a spread of 1.45% over Treasuries, which "seems expensive to me," says Bill Larkin, portfolio manager for fixed income at Cabot Money Management in Salem, Mass.

Bond managers say that companies in their tender announcements are often offering to buy back bonds at less than their contractual value. Even at the lower rates, the total yields on these bonds maturing in 2010 or 2011 can be 2% to 3%, a higher return than what cash is yielding, says Murphy.

Both Murphy and McGonigle are tendering their bonds selectively. Given the discounted offers, "if we like a company and like the security, we'll hold on to it until it matures," says McGonigle. "If we think the company is offering us a good exit opportunity and a good return, we'll take the tender [and accept newly issued debt] or exit the bond altogether."

The refinancing at lower interest rates and with more forgiving debt covenants suggests a less ominous outlook for corporate defaults than was apparent a few months ago, say Labrinos. Instead of defaults peaking around 12% to 15% in the first quarter of 2010, he now expects them to peak at 12% around November and start dropping from there into the start of the new year. That may give some investors more stomach for the high-yield market—and offer further relief for companies caught in the most vicious credit squeeze in generations.

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