• Market Update
• Newsletter
• Research
• News
• Resources
• Primers
• Treasury Yield Curve
• Contact Us
• Site Map

The Evolving Risk / Reward Landscape

Print Format (PDF)

Written by Michael Cazayoux, Sector Portfolio Management

For a three-year period starting in mid-2002, the interests of stockholders and corporate bondholders were nicely aligned. Following the peak in corporate defaults that year, shareholders learned that in a highly levered world, their investments could be completely wiped out in the bankruptcy process. As a result, shareholders encouraged companies to pay down debt as quickly as possible to minimize default risk and thereby improve stock prices. The deleveraging was successful for both stockholders and bondholders as the Dow Jones Industrial Average rose by 13% and the Lehman Brothers U.S. Credit Index outperformed the overall market by 580 basis points during the same period. In this environment, a corporate bond portfolio manager could focus on the same business fundamentals that drive outperformance versus benchmarks in the equity markets.

LEVERAGED BUYOUT RISK
Starting in mid-2005, however, we started to be concerned about growing shareholder activism at the expense of bondholders (see Dwight's article "Event Risk Takes Center Stage"). Corporate defaults plunged from all-time highs in 2002 to very low levels by 2005. Shareholders quickly forgot the perils of high debt levels and encouraged companies to redirect the use of free cash to pay dividends and/or buy back stock, rather than to pay down debt. What is now good for stockholders is not necessarily good for bondholders.

Some management teams started to raise debt in order to finance stock repurchases and special dividends. Still others, bowing to pressure from activist shareholders, bought out their public shareholders altogether by increasing their debt load to multiples of preexisting levels. The resulting leveraged buyouts (LBOs) were good for stockholders but were often devastating to existing bondholders. In a typical LBO from last year, HCA, the largest for-profit hospital operator in the country, took itself private in a $33 billion LBO. Over a five-month period, from the time the rumors first emerged to the time the scale of the leveraging was fully appreciated, their 10-year corporate bonds widened by 340 basis points, which resulted in a 22-point loss for existing bondholders!

The pace of LBOs has spiked up in the last year- and-a-half with $188 billion worth of LBOs announced just in the first quarter of this year, according to Bloomberg (see Dwight's article " The New Face of Leverage in the Financial System"). The acceleration has been fueled by global liquidity and the prevalence of cheap financing exemplified by the combination of low interest rates and record tight spreads in the high-yield market. Meanwhile, equities have remained relatively cheap, on a price-to-earnings ratio basis, at a time when nearly every other asset class is trading at a premium. As long as financing remains on favorable terms, earnings stay strong, and stocks stay relatively cheap, the current LBO wave is not likely to ebb.

TRENDS IN PRIVATE EQUITY
Private equity firms have been steadily raising funds for the past ten years, but until recently they found few opportunities to put money to work. As a result, the funds have accumulated into a considerable war chest that is currently estimated to approach $600 billion, according to JPMorgan. With the ability to leverage that equity by as much as five times, these firms have the potential to control as much as $3 trillion worth of LBOs.

These firms, such as Blackstone, KKR, and Carlisle, have recently shown a willingness to pool their resources in order to go after larger targets. Nine of the ten all-time largest LBOs have occurred in just the last two years, with RJR Nabisco the lone exception. In the 1980s, LBO targets were typically smaller companies. Now, with the proliferation of private equity funds and hedge funds, the competition for smaller takeover targets has become crowded, driving up prices and therefore driving down returns. Currently the private equity firms are teaming up into consortia that have allowed them to make $30 billion to $40 billion LBOs somewhat routine. At that size, few companies would be considered too big to be off-limits, and since investment-grade corporate bond issuers are typically the larger, more established companies, this latest wave of LBOs has been particularly pernicious to bondholders.

PORTFOLIO POSITIONING
In the current environment, the safest strategy a corporate bond portfolio manager can follow is to target those sectors in which a strong balance sheet is a prerequisite. Banks, brokers, and insurance companies are the most obvious sectors because their ongoing financing costs and their sound financial conditions are integral to their business prospects. Electric utilities and other regulated industries also provide a safe haven. Regulated industries typically provide what is considered a vital community service; as such, the regulators are loath to allow them to take on excessive leverage or to pursue any other policy that might lead to risk of insolvency.

In other sectors where LBO risk has been prevalent, greater care must be taken to identify and avoid those individual credits that are the most likely takeover targets. To help in this regard, many broker-dealers have developed programs designed to identify companies that are most at risk. These "LBO screens" look for objective financial data that have been characteristic of takeover targets in the past. They typically flag the following attributes.

• An underperforming stock price, which indicates a vulnerability to shareholder activism
• Low enterprise value relative to cash flow, which makes an LBO more affordable
• Low leverage, which makes room for new debt capacity
• High and stable cash flows, which are supportive of higher leverage
• High cash balances, which can be used to provide partial financing

While these LBO screens are certainly a useful tool for portfolio positioning, they are not foolproof, and they often steer investors away from credits that actually could be good investments. Many of the criteria that flag a company as a takeover target, like low leverage and stable cash flows, are ironically the same things that are typically viewed favorably from a credit standpoint. This highlights the importance of considerations beyond traditional balance sheet and income statement analysis (see Dwight's article "The Importance of Credit Analysis in Today's Corporate Landscape"). It is important to understand a company's culture. Has it displayed a tolerance for leverage in the past? Have any of its top managers ever worked at a highly leveraged company?

A final layer of event-risk protection lies in the language of the individual securities themselves. Increasingly, corporate bond investors have been pressuring companies to include protective covenants in their recent new bond deals. The most common type is "change-of-control" language, which allows the holder to redeem the bond in the event of an LBO. A second form of covenant protection, coupon "step-up" language, requires the coupon to increase by 25 basis points for each ratings-notch downgrade by both Moody's and S&P. Both types of covenant language provide significant protection, and both are important to have when positioning the portfolio in sectors and in credits with significant event risk. As the language evolves for new issues, the corporate bond universe will increasingly develop into a market of haves and have-nots, where performance will be determined as much on a bond-by-bond basis as it is on a credit-by-credit basis.

CONCLUSION
Event risk has become the primary challenge facing investment-grade corporate bond portfolio managers. This is not likely to change anytime soon, as long as public equities remain relatively inexpensive and interest rates remain relatively low. In this environment, corporate bond managers who are able to position their portfolios to avoid LBOs will likely be poised to outperform their benchmarks.