Monday, July 8, 2013

Change of Seasons

I have always believed markets have seasons. The seasons themselves are not as interesting as the change among seasons. We appear to be currently undergoing one of the more interesting changes in years. The June Federal Reserve (Fed) announcement concerning the beginning of the end of its QE3 (quantitative easing) bond buying program this September promises to have major corporate finance implications. The Fed seems concerned that QE was creating market distortions, and was no longer needed.

The market response to the announcement was dramatic. It triggered a substantial stock market correction. More importantly, however, it produced a major bond market rout. The bell-weather 10 year Treasury (T10) jumped by 80bps almost overnight to 2.5% a level not seen since 2011. Credit spreads on other private debt instruments jumped even more. For example BB bonds credit spreads widened by almost 140bps. As a rough rule of thumb, bond prices drop by 1% for each year of a bond’s duration for every 1% increase in rates. Duration (Duration) is in effect a bond’s beta. Investors had been reaching for yield by going further out on the yield curve (i.e. taking increased duration exposure) for the past year to offset artificially low interest rates due to the QE3. Hence,  duration for many investors and bond funds exceeded 5 years. Thus they suffered massive June market value losses of more than 4% - even more for leveraged bond funds. Investor withdrawals from bond funds were large. PIMCO, a major bond fund sponsor for example, suffered billions of withdrawals in June as the market re-priced. The severity of this re-pricing rivaled the 1994 Fed surprise rate adjustment. Furthermore, the expectation for rates is a continued rise as markets adjust to a world without QE. Rates could increase to a more normal 3.5-4% pre-crisis level over the next year.

Consequently, investor bond appetite has declined, and issuers are curtailing bond offerings as the market adjusts. Some implications of these developments are as follows:

1)    Debt financed stock repurchases and recaps will slow as the relative cost of debt rises compared to equity. The impact on pending deals like Dell should be interesting.

2)    Decline in use of aggressive debt features such as PIK, covenant lite and second lien. Issuers will focus on more investor friendly straight debt instruments.

3)    Increased funding risk for debt-financed cash acquisitions involving non investment grade buyers. This will favor better financed strategic buyers over financial buyers.

4)    Debt capacity will decline as rates increase. This will depress purchase price and funded debt multiples.

5)    PE fund raising and exits will decline from near record 2Q13 levels.

6)    IPO and M&A volumes will suffer.

The abrupt market change highlights again the value of financial slack -“excess” capital and liquidity. Firms with slack will weather the adjustment process without any major disruptions. Additionally, they will have the capacity to engage in opportunistic transactions to capitalize on market mispricing.

Firms need to recognize the end of the multiyear QE based bond bull market. The means adjusting to new investor demands when designing instruments and transactions. It was great while it lasted, but he bull market bond summer season is over. This is not necessarily bad - it just means things will be different. These changes are what good corporate finance professionals are paid to recognize, improvise on, adapt to and overcome.


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