The recent trend in LBO activity bears watching for bond investors but even at the current pace would lag well behind the boom years of 2006 and 2007.  We are more concerned with valuation levels among corporate bonds on evaluating investment appeal.

Increasing merger and acquisition (M&A) activity, the threat of leveraged buy-outs (LBOs), and the risk they pose of removing cash safety nets while imposing more debt on corporate balance sheets has weighed on corporate bond performance in recent weeks. While corporate bonds have outperformed Treasuries year to date, according to a comparison of Barclays indexes, late January and early February 2013 have witnessed modest price declines as investors reassess LBO risk. While not all M&A activity involves an LBO, increasing LBO volume can erode credit quality metrics in the investment-grade corporate bond market. Steady LBO volume can also impact the high-yield bond market, as an increasing volume of highly leveraged companies can cause investors to demand lower prices and higher yields as compensation for a decline in broader credit quality metrics and a rise in overall default risk.

LBO-related volume accelerated in recent months, averaging $12 billion per month since August 2012, up from a monthly average of $6 billion through the first eight months of 2012, according to S&P data. In recent weeks, Dell made headlines with a proposed transaction that would take the company private and last week finalized details on what would be the largest LBO since 2007. As is typically the case in an LBO, the newly formed company takes on a significantly higher debt burden, leading to lower bond prices as investors price in greater default risk.

Trending, But Bears Watching
The recent trend in LBO activity bears watching but is important to keep in perspective. Even at the current pace of $12 billion per month, LBO activity would lag well behind the boom years before the financial crisis [Figure 1]. Acceleration from the current pace would leave overall LBO volume well behind 2006–2007 levels. In fact, the current pace would still put LBO-related new issuance on the low side of historical averages.

Conditions Ripe For Continued LBO Activity
Nonetheless, conditions remain ripe for continued LBO activity. Bond yields remain near record-low levels, which means the cost to finance an LBO transaction is low by historical comparison, and investor demand for yield remains very strong, as evidenced by robust corporate debt issuance over the past several months. The capacity of the bond market to absorb a large leveraged deal appears adequate based upon new issue demand.

However, a couple factors suggest that a big increase in LBO issuance is unlikely.

·         Fewer participants. LBOs during the boom years of 2006 and 2007 involved the participation of multiple private-equity (PE) firms. The universe of private-equity firms involved in such M&A activity is much smaller today, and so is the broad capability to produce LBOs in large volume. In the Dell example, private-equity firm Silver Lake Partners was the only PE firm involved, and the deal still required a loan from Microsoft Corp, an unusual partner, and Dell CEO’s personal commitment of his $3.8 billion ownership interest in the company. The two latter factors are unique to the Dell transaction and not representative of a pending LBO boom.
·         Equity performance. Since the end of the financial crisis, stock market gains have reached double digits in three of the past four years with the exception being a 2 percent return in 2011, as measured by the S&P 500 Index. Positive returns reduce the desire to initiate LBOs in order to boost stock-holder returns. In early 2006, equity investors, still accustomed to strong performance from the late 1990s, had only witnessed one year of double-digit gains, in 2003. The ease of obtaining leverage to potentially boost equity performance proved too tempting. Today, the scars of 2008 are still fresh in investors’ minds, and the subsequent failure of large LBOs from 2006–2007 argues against a sharp increase in LBO activity.

To be sure, strong demand for new issue corporate debt along with record-low yields has loosened the constraints on corporate debt issuance. In recent months, issuance of covenant-lite bonds (i.e., bonds issued with fewer legal protections for bondholders) and more speculative structures have become more common. Both factors, along with the increase in LBO-related issuance, are signs of weakening credit quality, which may impact the broader markets. So far, however, the modest shift in issuance trends is occurring at the fringes and is not representative of the broad market. Aside from LBOs, issuance trends do not show signs of broad-based deterioration and remain far removed from pre-financial crisis norms [Figure 2]. The share of lower-rated CCC-rated debt issuance remains subdued compared to 2007. In the high-yield bond market, refinancing continues to comprise more than 50 percent of new issuance, a healthy dynamic.

While mindful of issuance trends, we are more concerned with valuation levels in the corporate bond market. The decline in yield spreads from mid-November 2012 to mid-January 2013 was quick and sharp, especially in the high-yield bond market, putting corporate bond markets on an unsustainable path. We still favor corporate bonds, high-yield and bank loans in particular, as current valuations compensate for the level of expected defaults, and credit quality fundamentals remain strong. The sector still stands out in what is likely to be a very low-return environment for bonds in 2013. The average yield spread of high-yield bonds to Treasuries has increased to 5.3 percent, up by 0.4 percent from mid-January 2013, while defaults remain subdued at 2.5 percent according to Moody’s.

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