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LBO Debt Alarms Fidelity, Lehman, TIAA-CREF Managers (Update2)
By Cecile Gutscher and Caroline Salas
July 5 (Bloomberg) -- The world's biggest bondholders have had their fill of leveraged buyouts, convinced that increasing mortgage delinquencies will drag down the U.S. economy and drive debt-laden companies into default.
TIAA-CREF, which oversees $414 billion in retirement funds for teachers and college professors, is boycotting some debt offerings used to finance LBOs. Fidelity International, a unit of the world's largest mutual fund company, and Lehman Brothers Asset Management LLC, the money-management arm of the third- biggest bond underwriter, say they're avoiding debt from buyouts.
Investors are getting skittish just as private-equity firms led by Kohlberg Kravis Roberts & Co. and Blackstone Group Inc. prepare to sell $300 billion of bonds and loans to finance LBOs, according to Bear Stearns Cos. In the past two weeks alone, more than a dozen companies were forced to postpone or restructure debt sales.
``There are some very scary analogies between high yield and the mortgage market,'' said Kevin Lorenz, a managing director who oversees $2.5 billion of high-yield assets at TIAA- CREF in New York. ``You cannot do fundamental analysis and believe that those are creditworthy companies.''
Leveraged buyouts caused sales of high-risk, high-yield debt to rise 70 percent to a record $1 trillion during the first half of the year, according to data compiled by Bloomberg. Bonds and loans rated below BBB- by Standard & Poor's and Baa3 by Moody's Investors Service are considered below investment grade.
Housing Woes
More securities than ever have the lowest rankings, with CCC ratings assigned to 26.5 percent of the new debt, according to New York-based Fitch Ratings. That compares with 15 percent in 2006 for debt that Fitch says has a ``high default risk.''
The combination of the worst slump in home prices since the Great Depression and the slowest U.S. economic growth in four years during the first quarter is driving investors away from riskier debt. The national median price for a previously owned home will probably drop 1.3 percent this year, the first decline since the 1930s, according to the National Association of Realtors in Chicago.
Traders demand 3 percentage points in extra interest to own U.S. junk bonds rather than government debt, compared with a record low of 2.41 percentage points on June 5, Merrill Lynch & Co. index data show. That's the fastest increase in spreads since April 2005, just before General Motors Corp. and Ford Motor Co. lost their investment-grade credit ratings.
`Out of Control'
Junk bonds lost 1.61 percent last month, the most since March 2005 when GM forecast its biggest quarterly loss since 1992. Junk bonds globally returned 2.88 percent in the first half, the lowest in two years, according to data from New York- based Merrill Lynch.
Investors withdrew $502 million from high-yield mutual funds in the week ended June 20, the most since September 2005, according to AMG Data Services in Arcata, California.
Fidelity International is ``underweight'' junk bonds, said bond fund analyst Sukrita Sethi in London. That means the firm owns a smaller percentage of the securities than is contained in benchmark indexes.
``Demand has spiraled out of control,'' said Sethi, who helps oversee $2 billion at Fidelity International, an affiliate of Boston-based Fidelity Investments. ``We think the market is overpriced. There's a little bit more scope for spreads to tighten, but a lot more scope for widening.''
ServiceMaster Co., the Memphis, Tennessee-based owner of TruGreen LawnCare and Terminix pest control businesses, pulled a sale of $1.15 billion of bonds to finance a $4.7 billion leveraged buyout by Clayton Dubilier & Rice Inc., this week.
Meeting Resistance
US Foodservice, the caterer in Columbia, Maryland, purchased by KKR, Seoul-based automaker Kia Motors Corp., Banco Schahin SA in Sao Paulo and Rotterdam-based Arcelor Mittal, the world's largest steelmaker, were among companies that canceled or cut back more than $8 billion of borrowing in the last two weeks.
Carphone Warehouse Group Plc in London, Europe's largest mobile-phone retailer, said today it postponed its debut sale of bonds indefinitely because of market volatility.
Some of the companies are meeting resistance because they want to limit standard investor protections, or covenants, such as restrictions on the amount of debt they can use compared with cashflow. So-called covenant-lite debt accounted for one-third of the high-yield, or leveraged, loans this year, according to S&P's Leveraged Commentary and Data unit.
Toggle Notes
Bonds that allow companies to pay interest in extra securities instead of cash, including toggle notes, accounted for almost 9 percent of high-yield debt sold this year, compared with less than 1 percent three years ago, Bank of America Corp. said in a June 21 report.
KKR and Clayton Dubilier, both based in New York, planned to use toggle notes and covenant-lite loans in the $7.1 billion acquisition of US Foodservice.
When investors wouldn't buy the debt, the company reduced the amount of toggles, added cash-interest senior notes and agreed to a private sale of senior subordinated discount notes on June 22, according to Montpelier, Vermont-based high-yield research firm KDP Investment Advisors Inc.
US Foodservice
Still failing to entice buyers, US Foodservice dropped plans for the toggles June 25. The next day, the company abandoned selling $1.55 billion of bonds and $1.57 billion of loans. Rob Meyne, spokesman for US Foodservice, didn't return calls seeking comment.
``Things are about to change,'' because companies will flood the market with junk bonds, said Ann Benjamin, head of high yield at Lehman Brothers Asset Management in Chicago, part of New York-based Lehman Brothers Holdings Inc. ``Some of those deals are overleveraged and will have weak covenants. We are going to be very cautious on the new issue calendar.''
LBOs, acquisitions where buyers typically use debt for about two-thirds of the company's purchase price, are paying more in interest compared with earnings than at any time in the last 10 years, according to data compiled by S&P.
Earnings before interest, taxes, depreciation and amortization, or Ebitda, cover interest payments on their loans by 1.79 times, down from 2.32 times at the end of last year and a peak of 3.2 times in 2002, S&P data show.
US Foodservice's debt would have been 9.3 times its Ebitda had the LBO been financed as planned, according to KDP. The average leverage ratio for 271 companies rated BB or B was 3.6 times at the end of March, according to Fitch. S&P gave US Foodservice's notes a CCC rating, and Moody's rated them Caa2.
CLO Demand
Bond and loan sales may be buoyed by demand from collateralized loan obligations, according to JPMorgan Chase & Co. high-yield strategist Peter Acciavatti in New York. CLOs package hundreds of speculative-grade company loans into securities with even bigger yields. Sales of CLOs doubled to $222 billion in 2006, and will probably increase 20 percent this year, according to JPMorgan estimates.
The junk bond market rebounded each time it cooled in the past five years and Acciavatti, the top-ranked high-yield bond analyst in Institutional Investor magazine's annual poll for the past four years, says they will return 8 percent in 2007. The firm is the biggest underwriter of bonds and loans with ratings below investment grade, Bloomberg data show.
``It's the triumph of liquidity over fundamentals,'' said Peter Harvey, who oversees $3.8 billion of assets as head of credit at Cazenove Capital Management in London. ``The creation of credit funds is unlike anything we've ever seen.''
KKR co-founder Henry Kravis called this the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia, in May. Yield spreads narrowed from the peak of more than 10 percentage points in 2002, saving companies almost $80 million in annual interest on every $1 billion borrowed in the junk bond market.
Dollar General
KKR is meeting investors in London today to borrow 9.02 billion pounds ($18 billion) to help finance its 11.1 billion- pound purchase of Nottingham, England-based drugstore Alliance Boots Plc with Italian billionaire Stefano Pessina in Europe's biggest LBO.
While defaults fell to 1.4 percent in May, the lowest in a decade, New York-based Moody's predicts they will more than double within a year to 3.4 percent of high-risk bonds.
KKR's underwriters wound up holding $725 million of toggle notes for the firm's $7.3 billion acquisition of Dollar General Corp. when they couldn't find investors who wanted to buy them last month, according to a person familiar with the situation who asked not to be identified because the arrangement wasn't made public.
Goldman Sachs Group Inc., Citigroup Inc., Lehman Brothers and Wachovia Corp. bought the securities, and plan to sell them when demand improves, the person said. Goldman and Citigroup are based in New York and Wachovia is in Charlotte, North Carolina.
`Look Pretty Risky'
The bonds would probably trade at about 94 cents on the dollar, or $43.5 million less than face value, said Justin Monteith, an analyst at KDP. Dollar General's debt is likely to be 8.1 times the Goodlettsville, Tennessee-based company's Ebitda, according to KDP.
Tawn Earnest, a spokeswoman for Dollar General, didn't return phone calls seeking comment. Mark Semer, a KKR spokesman, declined to comment.
``Historically, a deal with six times leverage was a stretch but doable,'' said Mark Durbiano, who manages $3.5 billion of high-yield bonds at Federated Investors Inc. in Pittsburgh. ``If you take a US Foodservice, a Dollar General, they're all well outside that.'' Those deals all ``look pretty risky with this leverage,'' he said.
First Data
KKR plans to issue $8 billion of high-yield bonds to help finance its $25.6 billion purchase of First Data Corp., the largest processor of credit-card payments, according to filings with the U.S. Securities and Exchange Commission. The sale would be the biggest junk bond offering since RJR Nabisco Inc. in 1989.
The LBO firm, co-founded by Kravis and George Roberts, will raise another $14 billion using covenant-lite loans for Greenwood Village, Colorado-based First Data.
``When companies need to issue those types of securities they're acknowledging they're not giving themselves any wiggle room,'' TIAA-CREF's Lorenz said of toggle notes and covenant- lite loans. ``The market has gotten ahead of itself.''
By Cecile Gutscher and Caroline Salas
July 5 (Bloomberg) -- The world's biggest bondholders have had their fill of leveraged buyouts, convinced that increasing mortgage delinquencies will drag down the U.S. economy and drive debt-laden companies into default.
TIAA-CREF, which oversees $414 billion in retirement funds for teachers and college professors, is boycotting some debt offerings used to finance LBOs. Fidelity International, a unit of the world's largest mutual fund company, and Lehman Brothers Asset Management LLC, the money-management arm of the third- biggest bond underwriter, say they're avoiding debt from buyouts.
Investors are getting skittish just as private-equity firms led by Kohlberg Kravis Roberts & Co. and Blackstone Group Inc. prepare to sell $300 billion of bonds and loans to finance LBOs, according to Bear Stearns Cos. In the past two weeks alone, more than a dozen companies were forced to postpone or restructure debt sales.
``There are some very scary analogies between high yield and the mortgage market,'' said Kevin Lorenz, a managing director who oversees $2.5 billion of high-yield assets at TIAA- CREF in New York. ``You cannot do fundamental analysis and believe that those are creditworthy companies.''
Leveraged buyouts caused sales of high-risk, high-yield debt to rise 70 percent to a record $1 trillion during the first half of the year, according to data compiled by Bloomberg. Bonds and loans rated below BBB- by Standard & Poor's and Baa3 by Moody's Investors Service are considered below investment grade.
Housing Woes
More securities than ever have the lowest rankings, with CCC ratings assigned to 26.5 percent of the new debt, according to New York-based Fitch Ratings. That compares with 15 percent in 2006 for debt that Fitch says has a ``high default risk.''
The combination of the worst slump in home prices since the Great Depression and the slowest U.S. economic growth in four years during the first quarter is driving investors away from riskier debt. The national median price for a previously owned home will probably drop 1.3 percent this year, the first decline since the 1930s, according to the National Association of Realtors in Chicago.
Traders demand 3 percentage points in extra interest to own U.S. junk bonds rather than government debt, compared with a record low of 2.41 percentage points on June 5, Merrill Lynch & Co. index data show. That's the fastest increase in spreads since April 2005, just before General Motors Corp. and Ford Motor Co. lost their investment-grade credit ratings.
`Out of Control'
Junk bonds lost 1.61 percent last month, the most since March 2005 when GM forecast its biggest quarterly loss since 1992. Junk bonds globally returned 2.88 percent in the first half, the lowest in two years, according to data from New York- based Merrill Lynch.
Investors withdrew $502 million from high-yield mutual funds in the week ended June 20, the most since September 2005, according to AMG Data Services in Arcata, California.
Fidelity International is ``underweight'' junk bonds, said bond fund analyst Sukrita Sethi in London. That means the firm owns a smaller percentage of the securities than is contained in benchmark indexes.
``Demand has spiraled out of control,'' said Sethi, who helps oversee $2 billion at Fidelity International, an affiliate of Boston-based Fidelity Investments. ``We think the market is overpriced. There's a little bit more scope for spreads to tighten, but a lot more scope for widening.''
ServiceMaster Co., the Memphis, Tennessee-based owner of TruGreen LawnCare and Terminix pest control businesses, pulled a sale of $1.15 billion of bonds to finance a $4.7 billion leveraged buyout by Clayton Dubilier & Rice Inc., this week.
Meeting Resistance
US Foodservice, the caterer in Columbia, Maryland, purchased by KKR, Seoul-based automaker Kia Motors Corp., Banco Schahin SA in Sao Paulo and Rotterdam-based Arcelor Mittal, the world's largest steelmaker, were among companies that canceled or cut back more than $8 billion of borrowing in the last two weeks.
Carphone Warehouse Group Plc in London, Europe's largest mobile-phone retailer, said today it postponed its debut sale of bonds indefinitely because of market volatility.
Some of the companies are meeting resistance because they want to limit standard investor protections, or covenants, such as restrictions on the amount of debt they can use compared with cashflow. So-called covenant-lite debt accounted for one-third of the high-yield, or leveraged, loans this year, according to S&P's Leveraged Commentary and Data unit.
Toggle Notes
Bonds that allow companies to pay interest in extra securities instead of cash, including toggle notes, accounted for almost 9 percent of high-yield debt sold this year, compared with less than 1 percent three years ago, Bank of America Corp. said in a June 21 report.
KKR and Clayton Dubilier, both based in New York, planned to use toggle notes and covenant-lite loans in the $7.1 billion acquisition of US Foodservice.
When investors wouldn't buy the debt, the company reduced the amount of toggles, added cash-interest senior notes and agreed to a private sale of senior subordinated discount notes on June 22, according to Montpelier, Vermont-based high-yield research firm KDP Investment Advisors Inc.
US Foodservice
Still failing to entice buyers, US Foodservice dropped plans for the toggles June 25. The next day, the company abandoned selling $1.55 billion of bonds and $1.57 billion of loans. Rob Meyne, spokesman for US Foodservice, didn't return calls seeking comment.
``Things are about to change,'' because companies will flood the market with junk bonds, said Ann Benjamin, head of high yield at Lehman Brothers Asset Management in Chicago, part of New York-based Lehman Brothers Holdings Inc. ``Some of those deals are overleveraged and will have weak covenants. We are going to be very cautious on the new issue calendar.''
LBOs, acquisitions where buyers typically use debt for about two-thirds of the company's purchase price, are paying more in interest compared with earnings than at any time in the last 10 years, according to data compiled by S&P.
Earnings before interest, taxes, depreciation and amortization, or Ebitda, cover interest payments on their loans by 1.79 times, down from 2.32 times at the end of last year and a peak of 3.2 times in 2002, S&P data show.
US Foodservice's debt would have been 9.3 times its Ebitda had the LBO been financed as planned, according to KDP. The average leverage ratio for 271 companies rated BB or B was 3.6 times at the end of March, according to Fitch. S&P gave US Foodservice's notes a CCC rating, and Moody's rated them Caa2.
CLO Demand
Bond and loan sales may be buoyed by demand from collateralized loan obligations, according to JPMorgan Chase & Co. high-yield strategist Peter Acciavatti in New York. CLOs package hundreds of speculative-grade company loans into securities with even bigger yields. Sales of CLOs doubled to $222 billion in 2006, and will probably increase 20 percent this year, according to JPMorgan estimates.
The junk bond market rebounded each time it cooled in the past five years and Acciavatti, the top-ranked high-yield bond analyst in Institutional Investor magazine's annual poll for the past four years, says they will return 8 percent in 2007. The firm is the biggest underwriter of bonds and loans with ratings below investment grade, Bloomberg data show.
``It's the triumph of liquidity over fundamentals,'' said Peter Harvey, who oversees $3.8 billion of assets as head of credit at Cazenove Capital Management in London. ``The creation of credit funds is unlike anything we've ever seen.''
KKR co-founder Henry Kravis called this the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia, in May. Yield spreads narrowed from the peak of more than 10 percentage points in 2002, saving companies almost $80 million in annual interest on every $1 billion borrowed in the junk bond market.
Dollar General
KKR is meeting investors in London today to borrow 9.02 billion pounds ($18 billion) to help finance its 11.1 billion- pound purchase of Nottingham, England-based drugstore Alliance Boots Plc with Italian billionaire Stefano Pessina in Europe's biggest LBO.
While defaults fell to 1.4 percent in May, the lowest in a decade, New York-based Moody's predicts they will more than double within a year to 3.4 percent of high-risk bonds.
KKR's underwriters wound up holding $725 million of toggle notes for the firm's $7.3 billion acquisition of Dollar General Corp. when they couldn't find investors who wanted to buy them last month, according to a person familiar with the situation who asked not to be identified because the arrangement wasn't made public.
Goldman Sachs Group Inc., Citigroup Inc., Lehman Brothers and Wachovia Corp. bought the securities, and plan to sell them when demand improves, the person said. Goldman and Citigroup are based in New York and Wachovia is in Charlotte, North Carolina.
`Look Pretty Risky'
The bonds would probably trade at about 94 cents on the dollar, or $43.5 million less than face value, said Justin Monteith, an analyst at KDP. Dollar General's debt is likely to be 8.1 times the Goodlettsville, Tennessee-based company's Ebitda, according to KDP.
Tawn Earnest, a spokeswoman for Dollar General, didn't return phone calls seeking comment. Mark Semer, a KKR spokesman, declined to comment.
``Historically, a deal with six times leverage was a stretch but doable,'' said Mark Durbiano, who manages $3.5 billion of high-yield bonds at Federated Investors Inc. in Pittsburgh. ``If you take a US Foodservice, a Dollar General, they're all well outside that.'' Those deals all ``look pretty risky with this leverage,'' he said.
First Data
KKR plans to issue $8 billion of high-yield bonds to help finance its $25.6 billion purchase of First Data Corp., the largest processor of credit-card payments, according to filings with the U.S. Securities and Exchange Commission. The sale would be the biggest junk bond offering since RJR Nabisco Inc. in 1989.
The LBO firm, co-founded by Kravis and George Roberts, will raise another $14 billion using covenant-lite loans for Greenwood Village, Colorado-based First Data.
``When companies need to issue those types of securities they're acknowledging they're not giving themselves any wiggle room,'' TIAA-CREF's Lorenz said of toggle notes and covenant- lite loans. ``The market has gotten ahead of itself.''
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