This Is an Outrage, Junk Market Says. Everyone Buys AnywayBy and
Old rule of thumb shows investors aren’t getting paid for risk
Other offerings make the grade but chip away at protections
Bond buyers have a rule of thumb that says be wary when the coupon on a new debt sale slips below the issuer’s leverage. It’s an indicator that investors aren’t being paid enough for the risk they’re taking on.
This adage is being tested anew amid a bubble-like market, as issuers wear down buyers with deals that they’d spurn in almost any other era. One recent example is July’s $500 million sale from HD Supply Waterworks. The water and wastewater company priced the debt beneath its 6.3 level of leverage, which measures debt as a multiple of earnings.
Not only did the sale go through, but demand allowed HD Supply to boost it from $475 million and pay even less interest than initially asked, finishing at 6.125 percent.
It’s another sign of exuberance in high-yield markets that has veterans like Oaktree Capital Group LLC co-chairman Howard Marks sounding the alarm. Investors are “at it again,” Marks said, funding risky deals and driving valuations so high that prospective returns in most asset classes are “just about the lowest they’ve ever been.” Junk-debt investors are getting only 3.49 percentage points of extra compensation compared with risk-free government debt, close to a post-crisis low. Other deals have softened language that protects creditors’ rights.
“The pendulum has been swinging back toward the issuer when it comes to negotiating ultimate terms,” said Michael McEachern, head of public markets at Muzinich & Co., which oversees about $30 billion. “When there’s a new issue with any kind of yield, usually more than 6 percent, it is generally going to do well.”
The erosion was exemplified in a deal from AssuredPartners Inc., the insurance brokerage that came to market with $450 million of bonds last week. It was immediately confronted by the ubiquitous troublemaker for aggressive corporate issuers, Covenant Review, which flagged language in the credit agreement being shopped around. The preliminary terms of the bonds were already “wildly off market," Covenant Review said, and created a loophole that decreases the likelihood bondholders would get expected payments should the company be sold.
That didn’t seem to matter. AssuredPartners received about $3 billion in orders for the bonds, allowing it to not only keep those provisions but also to boost the size of the sale to $500 million, according to people with knowledge of the transaction. That’s for bonds rated Caa2 -- a ranking that denotes very high credit risk. A representative for Apax Partners, which owns AssuredPartners, declined to comment.
“You’re seeing sponsors being very aggressive,” said Valerie Potenza, New York-based head of high-yield research at Xtract Research LLC, which analyzes debt deals. “They are testing the water to see where the line is.”
Even when investors have been able to win concessions, they lose elsewhere. Vivint Inc., the home-security company owned by Blackstone Group LP, tested the limits by trying to take a hatchet to customary payouts that bondholders would get if the private-equity giant sold its stake. While that provision was taken out, the bond sale went through and investors accepted a lower coupon than was initially discussed.
Representatives for HD Supply Waterworks and Clayton, Dubilier & Rice LLC, the private equity firm planning to buy it, didn’t respond to messages. Vivint and Blackstone didn’t have an immediate comment.
A credit-default swaps index that serves as a gauge of apprehension in credit markets slid to a three-year low last month. The index typically falls when perception of credit risk decreases and rises when sentiment deteriorates.
Amid the current effervescence, some investors are questioning whether they want to be the very-top performer, given the extra risk they’d have to take. The $630 million Diamond Hill corporate credit fund is beating 99 percent of its peer group for three years, according to performance data compiled by Bloomberg, but portfolio manager John McClain is more than happy to give up the front-of-the-class mantle right now.
“If you had a great 2007, that turned out to be something to be ashamed of," McClain said. "Fear of missing out in a strong market is pretty dangerous. A lot of that is going on now.”
— With assistance by Nabila Ahmed