LBOs Imperil $940 Billion of U.S. Company Bonds: Credit Markets

Investors holding almost $1 trillion of the lowest-rated U.S. investment-grade corporate bonds are at a greater risk of losses as the pace of buyouts surges to the fastest pace in six years because the debt offers few protections.

About $940 billion, or 58 percent of the $1.6 trillion of securities in the Bank of America Merrill Lynch US Corporate Index with ratings in the BBB tier, lack safeguards that would allow creditors to sell the debt back to the issuer at a premium in the event of a merger, according to data compiled by Bloomberg. Leveraged buyout deals from H.J. Heinz Co. and Virgin Media Inc., totaled $51 billion last month, the most since April 2007, according to JPMorgan Chase & Co.

Investors who have seen gains in the debt of almost 59 percent since the 2008 collapse of Lehman Brothers Holdings Inc., now face the threat of their claims being weakened by more senior-ranking lenders financing buyouts. Borrowers have already obtained more than $160 billion in speculative-grade loans this year, compared with $300 billion in all of 2012, according to JPMorgan.

“Most bonds are trading at a pretty high premium and could face significant price erosion,” Natalie Trevithick, who oversees $35 billion as head of investment-grade debt at Los Angeles-based Payden & Rygel, said in a telephone interview. “After the Lehman crisis, when LBO risk went away, the change of control term was not standard format and those bonds are still outstanding.”

Investor Protection

Before the crisis, many bonds were sold with provisions that forced companies to repay securities at a premium to par, or above 100 cents on the dollar, if they were bought in a leveraged buyout. Such debt-fueled transactions often result in the borrower’s credit rating being cut to below investment grade, or junk.

The almost 2,900 BBB bonds in the Bank of America Merrill Lynch index trade at an average price of about 111.3 cents on the dollar, or 6.4 cents above the average over the last decade.

“Our research shows that the level of protection in U.S. investment-grade bonds generally is not all that great,” Alexander Dill, head of covenant research at Moody’s Investors Service, said in a telephone interview. “A change of control is the most meaningful form of investment-grade protection against event risk like an LBO.”

Swap Spreads

Elsewhere in credit markets the cost of protecting corporate bonds from default in the U.S. rose, with the Markit CDX North American Investment Grade Index, investors use to hedge against losses or to speculate on credit worthiness, increasing 0.2 basis point to a mid-price of 78.5 points as of 12:15 p.m. in New York, according to prices led by Bloomberg.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 0.12 basis point to 13.75 basis points. The measure widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.

Bonds of Fairfield, Connecticut-based General Electric Co. were the most actively traded dollar-denominated corporate securities by dealers, accounting for 5.39 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Borrowing Costs

Record low borrowing rates engineered by the Federal Reserve and an improving economy are combining to make leveraged buyouts more attractive. Investors are paying an average of 98.17 cents on the dollar to buy pieces of leveraged loans, up from the record low 59.2 cents in December 2008, according to the S&P/LSTA U.S. Leveraged Loan Index.

The average spread on loans purchased by non-bank lenders, such as CLOs, was 377.6 basis points last month, down from 515 at the end of June, according to S&P Capital IQ Leveraged Commentary and Data. At the height of the market in March 2007 spreads were as tight as 243.3 basis points.

“It is important to think big about the kind of deals that can get done,” Stephen Antczak, the head of U.S. credit strategy at Citigroup Inc. in New York, said in a telephone interview. “The Fed is encouraging everybody to take risk. As investors are increasingly focused on boosting returns, they are likely to force corporate managers to help them do that.”

Heinz Buyout

Warren Buffett’s Berkshire Hathaway Inc. and Jorge Paulo Lemann’s 3G Capital agreed to buy ketchup maker Heinz for about $23 billion, according to a Feb. 14 statement.

Investors owning about $900 million of Heinz’s existing bonds won’t be able to sell the securities back to the company because there are no change of control covenants, according to a March 6 Moody’s report. The merger may double Heinz’s ratio of debt to earnings, according to a Feb. 15 Fitch Ratings report.

Fitch cut its rating on Heinz to BB-, or three levels below investment grade, on March 12. Both Moody’s, with a Baa2 rating, and S&P, which has the company one level higher at BBB+, have placed Heinz on a “negative” watch. Heinz’s 6.75 percent $436 million notes maturing in March 2032, which were trading at 125.1 cents on the dollar, lost as much as 24 cents the day after the deal was announced, Bloomberg prices show.

Virgin Deal

Heinz’s takeover is being financed with $12 billion in loans and $2.1 billion in bonds, the most amount of debt raised for an LBO since a group led by KKR & Co. and Texas Pacific Group borrowed $24.5 billion when they bought Energy Future Holdings Corp. for $48 billion in 2007, data compiled by Bloomberg show.

John Malone’s Liberty Global Inc. agreed to buy Virgin Media for $16 billion last month. The deal is being financed with about $3.65 billion in speculative-grade bonds and about $4.7 billion of loans, data compiled by Bloomberg show.

The cost of insuring against losses on Virgin Media debt using credit-default swaps has climbed as much as 120 basis points since the deal was announced to 382 basis points, Bloomberg prices show.

“The combination of low yields, high levels of cash on corporate balance sheets, strong demand for high-yield loans and receding global risks have spurred LBO activity recently,” analysts at JPMorgan led by London-based Nikolaos Panigirtzoglou wrote in a March 1 report.

Financial Bonds

Payden & Rygel has updated its models to screen for potential LBO candidates that would cause bond prices to fall, Trevithick said.

“We prefer investing in financials relative to industrials as you don’t have the same sort of event risk associated with them,” Trevithick said. “Financial institutions are so large that there is a lesser threat” of a corporate raider “coming in and doing an LBO,” she said.

Buffett’s bid for Heinz, which previously wouldn’t have been considered a typical target for a buyout, indicates the need for creditors to carefully analyze their portfolio, according to Pieter Staelens, a London-based analyst at Henderson Global Investors, which oversees about $25 billion in fixed-income assets.

“Lack of change of control is definitely a problem that investors have to worry about,” Staelens said in a telephone interview. “If you are an investor in these bonds, you need to make sure exactly what you own and how much protection you have against potential LBOs.”

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