Wednesday, December 12, 2012

De Ja Vu All Over Again-The Return Of The Spring Menu

Numerous Federal Reserve actions, including QE3 and Operation Twist, have flooded the markets with liquidity, depressed interest rates and flattened the yield curve. Domestic banks, unlike those in Europe, are well capitalized and have the capacity and willingness to lend. Investors searching for yield, but unwilling to assume equity tail risk have a large appetite for debt securities. Investment grade securities have priced so aggressively that more investors are marching up the risk curve.

The demand for noninvestment grade firms and higher 'risk structured' credit product is growing at a rapid rate. It is starting to feel like the pre-crisis 2005-2007 period. It is a good time to be an issuer/borrower. Hence we are seeing the return of bull/spring market debt capacity enhancing products as outlined in my prior post Back in Fashion Again. These include PIK, second lien loans and covenant lite.

High yield bond issuance (non-investment grade issuers with ratings below BBB-) is up 35%+ over 2011.The inflow of new investor funds into high yield bond funds is driving the demand for these instruments. Equally important is the growth in leveraged (non-investment) borrowers. Volumes are up 25% over the prior. They have reached their highest level since the crisis and the third highest level in history.

The majority of leveraged loans are structured as term loan “B” and sold to nonbank institutional investors. These investors are attracted to the asset because of the high yields LIBOR + 450-525 basis points with LIBOR floors of 125 basis point for the Bs and LIBOR + 900 on second lien loans. Additionally, they like senior secured floating rate features.

The return of collateralized loan obligations (CLO) is another development increasing the demand for leveraged loans. CLO are securitization vehicles that purchase and pool leveraged loans. They then tranche instruments used to fund their investments with lower rated tranches serving as enhancement for the higher rated tranches. CLO volume has increased to over $50B this year compared to just $12B in 2011. This is yet another sign of increased investor risk appetite.

M&A volume is highly dependent on credit. If credit is available bidders will use. This is reflected in rising M&A volumes, elevated purchase pricing and larger transactions. A current example is Freeport-McMoRan’s combined $10B acquisitions of two oil and gas firms at significant premiums. Although remaining marginally investment grade at BBB/negative outlook and a stock market beta of 2.3, JPMorgan felt comfortable enough to act as sole initial underwriter for $9.5B of loans.

It is important to remember that these market windows of financing opportunity can close abruptly-especially for lower rated firms and higher risk structures. Significant macro headwinds including the fiscal cliff, slow growth and Europe still remain. Therefore, I strongly suggest the following:

  •  Locking in your financing with as few lender outs as possible. Borrower bargaining power has increased.
  •  Be prepared to assume pricing and structure flex clauses in commitment letters. These allow lenders to increase pricing and reallocate portions of the loan if market condition change to clear the market.
  •  Try to build financial flexibility into your merger agreements.

You can only take what the market offers. Currently the credit markets are in a holiday mood and offering a lot. So take it while you can, but be prepared should conditions change.


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