Credit investors have been riding a high wave in the past few months. We have been sceptical of the breadth and duration of this exuberance for three main reasons:
1) The collapse of the shadow finance system. While issuers were historically allowed to offload capital needs to synthetic structures such as securitization and off balance sheet vehicles, companies now, more than ever, are forced to meet financing and refinancing needs in traditional pathways, involving convincing the investor pool of fundamental investment suitability.
2) Limited availability of capital and increasing near term maturities. With the industrial strength Treasury issuance ramp up only just starting, $350 billion of investment grade maturities over the next two years, as well as a more limited investor universe due to the viral redemptions at hedge funds and woeful performance at mutual funds, many companies will be forced out due to the simply physical lack of access to refinancing dollars.
3) Exploding IG - HY spreads and other fundamental considerations. As the cost of capital grows exponentially the lower on the rating agencies' totem pole a company lies, perfectly executed business plans will be a necessity and credit investor vigilance will become a prerequisite. Once a downgrade succession starts, it will become next to impossible for a company to avoid the double whammy of worsening leverage metrics and investor sentiment, especially in the recessionary environment over the next 2-3 years.
So as accounts evaluate new opportunities and consider the refinancing risk of new candidates, they should keep in mind the following key considerations: i) debt issuance prospects, ii) current liquidity, and iii) borrowing alternatives.
Debt Issuance Prospects
Maturity Schedules: Focus on upcoming notional and date of maturities, market price and maturing debt's features over the next 3 years. Also important is whether maturities coincide with deeply subordinated issuance or fall in big maturity years: what will bondholders realistic bargaining options be? Lastly, is the future refi event also a possible default event?
Market Access Risk: Where in the subjective preference universe of investors does a company fall? Is it from a tainted sector (autos) or preferred (utilities and healthcare)? Will there be major industry risks ahead? Some industries such as consumer and retail will be more prone to defensive issuance while the IG window is open, as downgrade threats will escalate refis to the point of impossibility. From an equity stand point, the inability to access unsecured debt markets will be a major threat to expansion plans, and other shareholder friendly events. Implicitly this means that equity valuations of debt-laden companies will become more and more credit-nuance dependent, as the credit market access variable will define an increasingly more critical cost of capital and its impact on the balance sheet and cash flow statement.
Repricing Risk: A safe generalization is that for HY names, refinancing bonds will be a Sisyphean task at the unsecured level due to prohibitive spreads (Landry's just priced new issue with a 14% coupon at an 88 price is a pipe dream: we predict it will drag the company into bankruptcy within 1-2 years max). Additionally, new issues have been pricing at negative basis to CDS recently, and thus CDS levels are a good indication of where to expect new issue pricing given a specific discount. Some very risky IG names from this perspective would be BBB-rated automotive names such as BorgWarner and JCI, as due to their tainted nature they will need to price at an abnormally high yield, thereby pushing a self-referential downgrade in implicit and explicit credit risk.
Liquidity Snapshot Analysis: Simply stated this means whether cash on hand + undrawn credit facilities + free cash flow are sufficient to handle a longer or shorter lock out from the primary markets? How about total lockouts or just CP lockouts? While this kind of check has been routine for HY analysts, it is becoming de rigeur for Crossover names and even standard IG names (it was what many people did on AAA rated GECC).
Bank Line Capacity: Bank lines backstop everything from seasonal W/C swings, letters of credit, debt maturities and commercial paper. Two main questions here are: how much is available for draw down now and can new lines be established. Recent market actions have indicated banks' willingness for cash collateralization of numerous cross over names, as well as increasing securitization of previously uncollateralized bank lines at names such as Gannett. When considering existing credit lines, it is important to evaluate maturities and sizes, what are covenants (maintenance and incurrence tests), how much is committed to international operations, if there is a revolver draw down, is it due to unforeseen circumstances or to proactively address systematic threat in the banking system, and from a covenant stand point: how much asset pledging carve out room is there, what is the reference pool of assets, and what is are reference assets for lien baskets. Lastly, an important question is who is in the lending group: many bank deals in which Lehman, Bear or Merrill were administrators or lead lenders were in jeopardy as investors did not know how to approach a lack of clear cut successor situation.
Is there a Government Backstop Program Available: As we wrote earlier, there are numerous government programs available to subsidize virtually all parts of the balance sheet and provide liquidity. With programs such as the TLGP, TALF and CPFF springing up at a moment's notice upon regulatory contemplation, these can be game changing events: AAA-rated GECC may have been bankrupt now if the Fed had not stepped in at the 11th hour to provide immediate CP assistance.
Security/Structural Subordination: A concern for borrowers migrating down the capital structure is being structurally subordinated. As most IG bonds and pre 2007 bank lines are covenant lite, they carry a large risk of being layered. If bank lines have springing liens which upon a downgrade become secured (again ala Gannett), existing bondholders will end up with proratedly lower recoveries due to their collateral pool becoming notably smaller. As more banks try to follow GCI's example, issuers will resist ratings triggers driving liquidity events but may not have choice but to acquiesce to asset pledging. A concentrated bank system with less competition will only makes this a more distinct reality for borrowers.
Investment Grade Indenture Analysis: The same holds true for bondholders of investment grade securities. The question will be how the asset mix of any given issuer could get encumbered based on the carve-out language in the limitations-on-liens covenants.
Equity-Linked Market Alternatives: If dislocations in the credit market persist, it would make sense for companies to raise capital via convertible and other equity-linked products. The last time this occurred was in 2002 when the IG and HY markets again were on the verge of collapse. The problem now is that hedge funds are getting the short end of the stick regarding funding lines as well as collateral and counterparty risk, exacerbating cash to synthetic aberrations. Hedge funds are still facing redemption risk and convert arbs players who came to the rescue of the HY market in 2002 have not been around for several years and are unlikely to comr back at all. A recent name that took advantage of the cvt market to the surprise of investors was Radioshack, while more erudite historical examples in the 2001-2003 period include Lucent, Nortel, Tyco and Gap. The CDS market needs to be deep and liquid to overcome the absence of pure-play convert players, and must consist of entities that are not merely hedging but actively trading. So as regulators consider how to abolish the CDS market (an issue we most recently wrote about here), they should realize that CDS are likely integral in pulling the credit market out of its existing near-comatose state.
Financing Options: the ability to sell assets has saved many troubled companies in the past, and thus it is critical to keep an eye on the asset sale market to evaluate potential sources of last-ditch liquidity available. It is no secret that, in terms of market influences, strategic buyers will be more active than financial buyers in coming months, while private equity will be dormant for fears it may enter the market at high valuations yet again while faced with increasingly weary LPs. Additionally, industry segregation will continue with some industries, such as pharma, healthcare and energy much better positioned for asset sales compared to auto, homebuilders, and consumer cyclical. And of course, the strategic acquiror universe will be much smaller as well and potential purchasers will likely have unlevered balance sheets with lots of disposable cash. An interesting case here is Louisiana Pacific, which investor are virtually convinced will file for bankruptcy soon, however the belief is that some imaginary strategic will pay for their assets a hefty price of 70 cents on the dollar even in liquidation (when all close comps are on the verge themselves), which is why LPX CDS trades incomprehensibly tight.
This is merely a partial attempt at quantifying the refinancing risks which investors should be aware of as they consider investing in credit opportunities. Undoubtedly the near term (2009 and 2010) presents significant risks, which is why we caution credit funds from rushing blindly into opportunities that aside from a technical run up have very little else going for them. And again we welcome comments and insight.
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