The credit crunch story continues this week as a few private equity deals were shelved due to lack of interest in new high yield debt offerings. This, along with the usual stories of subprime and housing sales, are being blamed for stocks' recent drop. Today's Wall Street Journal features some timely data on the subject:
Banks Delay Sale of Chrysler Debt as Market Stalls
By Dennis K. Berman, Serena Ng and Gina Chon, The Wall Street Journal (*site requires registration)
Debt Investors Grow Decidedly Cautious
By Michael Aneiro, The Wall Street Journal (*site requires registration)
Scorecard: Debt Dilemmas: How Credit-Market Tremors Have Affected Junk Bonds, LBOs and Hedge Funds
By the Editorial Staff, The Wall Street Journal (*site requires registration)
Indeed, pervasive market satiation for new debt would be a legitimate concern for stock investors. Equity markets are clearly worried about the recent difficulties LBO funds have had raising money, and MarketMinder has often highlighted the M&A boom as a key driver of the bull market. But we still see little true cause for alarm at the moment…though this is something to keep an eye on. See these past MarketMinder commentaries for more:
• Credit Crisis Conundrum (7/12/07)
• Runaway Rates? (6/15/07)
One question you should ask is: Do I really understand how debt markets work? Particularly those wonky kinds like Collateralized Debt Obligations (CDOs), Mortgage Backed Securities (MBS), and so on? These terms are thrown around a bunch in the press, but we suspect many folks don't fully understand how these markets function. Before you decide it's worth your time to worry about credit markets, you should understand how these things work. Wikipedia has a few excellent entries on the subject, which we recommend:
Private equity deals are mostly financed by high yield debt. Interest rates are benign by historical standards, making debt cheap right now—even the high yield stuff. This makes M&A very attractive because it allows attractively priced firms to be purchased with cheap money.
But it's one thing to say you're going to buy a company using debt, and another thing to actually sell that debt to the open market and make the deal happen. Over the last days, many of the usual buyers of high yield debt aren't biting. The question is: Is this just a temporary lull, or will investors demand higher interest rates in the immediate future?
Investment banks that underwrite new debt have big incentives to keep these deals alive. In times when it's difficult to find a buyer, there are basically three options:
1. The deal could be scrapped, but the investment bank would lose its big fees and damage its reputation.
2. The deal could be moved forward by simply raising the interest rate paid. This is undesirable for the private equity companies, who would have to pay more in interest expense, and might even make the deals unprofitable if interest rates rise too much.
3. The deal can be completed by having the investment banks supply the capital themselves as a "bridge" until the market rights itself and is ready to purchase the debt.
The third option is keeping today's Chrysler deal alive. However, this too is ultimately an undesirable tactic for investment banks because it requires them to put the debt entirely on their balance sheets. Small amounts such as a few billion bucks don't matter much—most of the big investment banks can take that on easily. But this isn't a long-term solution because investment banks don't have sufficient funds or risk tolerance to front all that capital for everyone. Eventually, the debt must be sold through the markets or the private equity boom will die.
If investors view loans as becoming meaningfully riskier, interest rates must rise. This is reflected in credit spreads—the difference between risk free government bonds and riskier bonds of similar maturities. The wider the credit spread, the more expensive the money and the less likely corporations and private equity shops will be willing to borrow. When corporations are sapped of one important source of expansion capital, earnings typically suffer, share buybacks dry up, and acquisitions become less affordable.
For example, in 1998 the now-infamous failure of Long Term Capital Management (LTCM) caused temporary investor panic and a short-lived but significant credit spread spike, as well as a hefty 20% stock market correction. But it's important to remember that the LTCM "crisis" didn't cause a global credit meltdown, and 1998 was still a great year for stocks!
Credit spreads have widened a bit recently, but volatility in this measurement is perfectly normal. The spread of AAA bonds versus 10-year treasuries is still less than 1% and well within the range it has traded within over the last four years of bull market. It's also worth noting that 10-year Treasury yields have backed off significantly to below 4.8%, indicating liquidity is plentiful.
Should a true credit crisis develop, credit spreads will widen significantly more. For now, their modest rise tells us money remains cheap and fairly easy, not as easy the extreme easy of earlier this year, but still quite easy. A true credit crisis has yet to arrive. So long as that continues, this week's market turbulence is likely to be short lived.
If borrowing rates spike significantly from here, the key driver of the share repurchase and acquisition boom will have gone away. Will that be the end of the bull market? Maybe, maybe not. Another fundamental driver could replace it to drive the bull still further, but it's premature to make such a pronouncement.
In the end, this is likely just a blip amid the larger trend. In fact, more highly scrutinized debt offerings by the market are likely a positive for the longevity of the LBO boom. However, in the short term, these loans seem to be piling up on banks' and Wall Street firms' books, and this backlog could delay some deals.
Time will tell, but this week's turbulence is ordinary in our estimation and no time to surrender your bullishness.