Commentary

High on Yield

After the internet-led technology bust of 2001-2002, a new, sober
approach to investing, corporate cash management, and risk-taking
began to take hold. During the dark and scary implosion that marked
the dawning of the new millennium, legions of newly-minted day
traders watched in horror as their dotcom portfolios plummeted,
and established tech giants like Sun Microsystems- the dot in dot-
mania-were caught in a death spiral once the magic carpet was pulled
out from under the market.

The massive terrorist attacks in the fall of 2001 helped nudge the
economy into a mild, and short-lived recession. Yes, it was a sobering
moment for America, and it was most noted for its brevity. Our
financial miracle proved to be a mirage, and the trillion and a half
dollars-give or take a hundred billion- that was allocated to national
defense could not thwart an assault by religious fanatics armed
with box cutters.

In response to this assault on the homeland, and the shallow recession
that followed, the President and Alan Greenspan, Fed Chairman at the
time, combined forces in order to resuscitate the American consumer
and restore business confidence. The President and the Republican-led
Congress pushed through massive tax cuts; Chairman Greenspan
slashed interest rates to levels that would inspire the dead to borrow
and invest.

Most Americans are well aware of the drastic escalation in home values
that accompanied the slide in interest rates and the disappearance of
lending standards, but there was another bubble forming in the financial
markets. Expansive monetary policy in America, combined with
historically low rates worldwide, and an ample flow of petrodollars
from the explosion in oil prices, set the stage for a drastic increase in
LBOs (Leveraged Buyouts) and Private Equity deals on Wall Street.
It is now safe to conclude that financial mania is back in style again.

The massive amount of money created by this deluge of liquidity had
to find a home- and fast. The LBO community has acted like a sponge,
soaking up over $300 billion since 2005, and since no one buys without
utilizing cheap credit, its buying power is actually calculated to be
$1 trillion.

According to an article in Barron’s this past December, 25 percent of
all domestic mergers and acquisitions in 2006 were the result of LBOs.
this compares to 15 percent in 2005, and only 5 percent in 1999.

The increase in LBO activity has set the high yield bond market ablaze.
This is where the funding for such deals originates. It is important to
examine the underlying concept of a leveraged buyout, which is to buy
an under valued asset- a public company with ample cash flow and low
debt- with money borrowed from bond investors- and sell off the most
valuable pieces, or take it public in the future for a profit. The use of
leverage amplifies the return on investment in a market that is
experiencing a sustained period of price appreciation, it is similar to
buying stock on margin, or a house with little or no money down.

The problem with this unfolding financial-engineering mania is that
bond investors are not being compensated for the risks they are taking.
Currently, high yield investors are receiving a mere 2.85 percent more
than they would if they had purchased risk free US Treasury bonds.
This is a historically low risk premium, and it is a far cry from the
10 percent spread over Treasury yields witnessed after the junk bond
market collapsed in the early 1990s. This is also a clear sign that
investors are ignoring potential hazards.

To make matters worse, the banking sector has jumped, eyes
closed, into the fray as well. The same people who christened the
interest-only, no money down mortgage are now throwing their hat
into a market that is already in frothing with speculative excess. As
LBO firms willingly take money from naïve bankers in order to reduce
interest costs, the returns on high yield debt will fall further as the
battle for extra crumbs of return heats up.

At the moment, the economy is still on relatively firm ground. But, any
number of shocks to the financial system, such as America’s financial
imbalances precipitating a dive in the dollar, or an oil crunch arising
from an expansion in Middle East hostilities, could lead to problems. The
“goldilocks” scenario of steady growth and low inflation that has been
transformed from a fairy tale into a widely accepted investment philosophy
could easily turn into a very real run-in with the bears.

It is the prospect of an economic disruption that is being completely
ignored by high yield investors, and US banks, in fact, there seems to
be nothing but blue skies on their radar screens. Any slowdown in
growth, or a recession, could cause companies saddled with LBO debt
to miss interest payments or default on their bonds.

It is important to recognize that this would result in a contraction of
available funds to all companies, public and private. Any implosion
in the high yield sector would ripple across the entire corporate bond
market, and since banks have been diving into this market recently,
access to credit for small businesses would suffer as well.

The speculative debt market has melted down before, most notably in
the early 1990s, after the collapse of Drexel Burnham and the sentencing
of Michael Milkin, and in 1998, after Long Term Capital Management,
a Greenwich Connecticut based hedge fund, had to be rescued from its
massive, disastrous gambles on emerging market debt.

The financial calamities experienced in speculative debt markets have
touched the broader bond and equity markets, and they can adversely
effect economic activity. Any trouble that bubbles to the surface as a
result of this mindless speculation will most likely do the same this
time around.

Greg Strid

© 2007 Splendid Marbles.