Conflicting signals in public, private debt markets

Depending on your news source, this is either a rosy or horrible time to raise new debt for your mid-large sized company.

The publicly-traded high yield debt market has taken a pasting this summer, with US$20 billion of fund outflows since June. It can’t be a good time to be a borrower with a new debt issue coming to market (from Reuters Breakingviews in London, H/T G&M):

Like an old-fashioned bank run, no one knows for sure what started the run on high-yield funds in July, 2014.

Deutsche Bank has a plausible account. It thinks so-called short-duration funds started to suffer outflows in May, perhaps because they had been particularly richly priced by yield-crazed investors. Then investors started to worry that the U.S. economy would soon be strong enough to support higher policy interest rates, which would make junk less attractive. Janet Yellen turned a jog into a run in July when the Federal Reserve chair said high-yield valuations “appear stretched.”

As the high-yield funds were selling, they ran into a shortage of buyers. Many investors were too worried about Ukraine to want many risky assets. The effect was dramatic. About $20-billion (U.S.) has been withdrawn from high-yield funds since June, Barclays believes, the longest consecutive period of outflows on record. High-yield spreads jumped 55 basis points in a month – with no sign that defaults were rising.

Now, I’d argue that a high yield offering in the range of 5 or 6 percent isn’t really much of a “high yield” per se. It is certainly higher than what government bonds of the same tenor would pay, but that’s not traditionally been a sufficiently attractive selling feature for investors; the rate had to be high on an absolute basis, not just a relative one. For investors who saw implied HY rates quickly back up 55bps though, the mark-to-market loss on the face value of their portfolio HY bonds was real. Even if a new HY issue would still be priced at an attractive rate from an issuers standpoint based upon historical norms.

There are still plenty of high yield issues in the 8% range these days, but, again, this paper is sporting a coupon which is ~300 bps lower than traditional interest rate levels for such issuers — despite the same notional expected rate of default.

It doesn’t make sense to me either.

The problem for issuers isn’t the quick 55bps jump in rates, it’s the fact that US$20 billion of investor capital was redeemed from funds over the past few weeks. The absence of liquidity within institutional and retail funds dedicated to high yield bonds usually serves to brutally shut the door to many new offerings.

In the private debt market, however, AltAssets is reporting that “Leveraged loans in US technology sector hit all-time highs” recently. Frankly, from what our firm has been seeing in 2014, this doesn’t come as a surprise (see prior post “Bloomberg: Regulators stand by while U.S. bank lenders get footloose” May 14-14).

It may strike you as odd that illiquid $20 million – $100 million loans for U.S. private technology companies have never been easier to find, all while the public high yield bond market is in a funk. There are a few reasons why this is happening, and they aren’t very complicated:

– some U.S. specialty banks are making it easier than ever for unprofitable tech firms to get meaningful loans booked, with the tacit support of the FDIC and Federal Reserve (so far)

– some hedge funds have returned to the sector, after fleeing in 2008

– as much as the IPO market has been open to tech names for most
of the past two years, new investment funds have been created to allow higher quality private firms to “Stay Private Longer”. These aren’t the pre-IPO equity vehicles that invested in Facebook or Twitter, which were designed to give some liquidity for shareholders prior to an IPO. This is actually capital destined for the company’s coffers to spend in an effort to grow revenue.

– the fact that these private company loans are illiquid often gives lenders the ability to carry them at more static valuation levels for accounting purposes, unlike publicly-quoted bonds whose notional values bounce around from day-to-day

As much as this might explain-away the current divergence in the two debt markets, it is impossible to predict who will blink first. Institutional lenders, who see two more years of lowish interest rates in the US and Europe, or private debt players (including banks), who might want to be cautious about booking deals today that will only serve to have their own LP investors, regulators and/or shareholders look back in 18 months and say:

“You did what?”

It almost takes me back to 2006-07 (see prior post “US mortgage liquidity crisis at hand” Mar 14-07). Which was soon followed by former Citibank CEO’s famous quote:

In July 2007, Prince told the Financial Times that global liquidity was enormous and only a significant disruptive event could create difficulty in the leveraged buyout market. “As long as the music is playing, you’ve got to get up and dance,” he said. “We’re still dancing.

Market players will never forget how that turned out, right? Right?

MRM