Bloomberg News

Bubble-Era Financing Returns as Profits Falter: Credit Markets

October 11, 2012

Bubble-Era Financing Returns as Profits Falter

Mizuho, Japan’s third-biggest bank by market value, sold $1.5 billion of five-year notes to yield 90 basis points more than similar-maturity Treasuries and $1 billion of 10-year debt at a relative yield of 130 basis points, Bloomberg data show. Photographer: Kiyoshi Ota/Bloomberg

A type of financing that peaked before credit markets seized up four years ago is staging a comeback just as concern mounts that corporate profits are falling and the global economy is losing steam.

Offerings of $2.1 billion in the past 30 days of so-called payment-in-kind notes, which allow borrowers to pay interest with extra debt, account for more than a third of this year’s $6 billion of deals, according to data compiled by Bloomberg. Pharmaceutical Product Development Inc., a Wilmington, North Carolina-based contract research firm, sold $525 million of the notes yesterday.

Sales of high-yield, high-risk bonds are soaring to a record pace as interest rates hover at unprecedented lows send investors toward riskier assets. JPMorgan Chase & Co. says credit metrics are deteriorating, with leverage at investment- grade borrowers potentially approaching financial crisis levels by year-end, as the International Monetary Fund lowers its global growth forecast to the slowest pace since 2009.

“You only hear about PIK bonds when the high-yield markets are really frothy,” William Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts, said in a telephone interview. The trend “is OK if we’re at that part of the cycle where things start to accelerate. But we don’t know that.”

‘Sellers’ Market’

Even as issuance of PIK bonds accelerates, sales are below the record $14.9 billion in 2007, Bloomberg data show. Sales fell to $14.5 billion the following year, as the failure of Lehman Brothers Holdings Inc. led to a credit freeze.

Relative yields on high-yield bonds reached a record 21.82 percentage points on Dec. 15, 2008, from that year’s low of 6.1 percentage points on Jan. 2, Bank of America Merrill Lynch index data show. Spreads have fallen to 5.61 percentage points as of yesterday.

“The increased use of payment-in-kind structures is confirmation that this is a sellers’ market,” Edward Marrinan, macro credit strategist at RBS Securities in Stamford, Connecticut, said in a telephone interview. “Many issuers are in a position to dictate terms to investors.”

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. declined. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreased 2.3 basis points to a mid-price of 96.7 basis points as of 12:12 p.m. in New York, according to prices compiled by Bloomberg.

Rate Swaps

The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.12 basis point to 12 basis points as of 12:12 p.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Bonds of Sprint Nextel Corp. are the most actively traded dollar-denominated corporate securities by dealers today, with 121 trades of $1 million or more as of 12:15 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Softbank Deal

Sprint said it’s in talks with Softbank Corp. for a “substantial” investment from the Japanese carrier. Sprint’s $2.48 billion of 6.875 percent, senior unsecured debt due November 2028 increased 10.9 cents on the dollar to 102.75 cents to yield 6.59 percent.

The seasonally adjusted amount of U.S. commercial paper contracted to the lowest level in five months, falling $10.2 billion to $964.9 billion in the week ended yesterday, the Federal Reserve said on its website. That’s the lowest level since May 2.

Corporations sell commercial paper, typically maturing in 270 days or less, to fund everyday activities such as payroll and rent.

Demand for PIK bonds underscores investors’ appetite for riskier assets. Sales of junk bonds in the U.S. are proceeding at an unprecedented pace, with issuance of $259.9 billion exceeding the $210.6 billion sold in the corresponding period of 2010, the busiest year on record, Bloomberg data show.

Riskier Assets

Yields on U.S. corporate bonds reached a record low 3.676 percent on Oct. 3, before climbing to 3.67 percent as of yesterday, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Master.

PIK toggle bonds allow borrowers to elect to pay interest in cash or through issuing more debt, or a combination of the options, generally within the first few years of the bond’s term, according to Moody’s Investors Service.

NBTY Inc., the maker of Nature’s Bounty and MET-Rx nutritional supplements, is offering $500 million of five-year PIK notes, according to a person familiar with the transaction. The securities will rank senior to the company’s existing and future debt and liabilities, said the person, who asked not to be identified because terms aren’t set.

Pharmaceutical Product’s offering was increased by $25 million from the $500 million initially planned, Bloomberg data show. The five-year debt pays 9.375 percent in cash and 10.125 percent if the company pays in the form of additional debt.

Jo-Ann Stores Inc., based in Hudson, Ohio, sold $325 million of seven-year PIK notes on Oct. 9 that pay 9.75 percent in cash and 10.5 percent if the company pays in added debt, Bloomberg data show.

Petco Debt

Five days earlier, Petco Animal Supplies Inc., owned by Leonard Green and TPG Capital, raised $550 million selling five- year debt that pays 8.5 percent in cash, and 9.25 percent if paid in added debt.

The debt from all three borrowers is rated Caa1 by Moody’s and CCC+ at Standard & Poor’s. Ned Glascock, a spokesman for Pharmaceutical Product, declined to comment on the offering. Representatives of Jo-Ann and Petco didn’t return telephone calls seeking interviews.

High-yield, high-risk, or junk, bonds are rated below Baa3 by Moody’s and lower than BBB- at S&P.

The securities provide issuers with flexibility if the economy weakens or the companies struggle to make cash interest payments, Sabur Moini, who manages about $2.5 billion of high- yield assets at Payden & Rygel in Los Angeles, said in a telephone interview. Hedge funds and other investors that favor riskier assets are typical buyers.

Investors find PIK securities appealing with the global speculative-grade default rate of 3 percent in September below the historical average of 4.8 percent in data going back to 1983, according to Moody’s.

‘Deteriorate Further’

Leverage metrics in investment-grade bonds are likely to have weakened in the third quarter because of a drop in earnings and a rise in debt, analysts led by Eric Beinstein at JPMorgan wrote in an Oct. 9 report. Leverage reached 1.98 times in the second quarter, compared with a crisis high of 2.11 in the third quarter of 2009 and a low of 1.86 in fourth quarter of 2010.

“There is little doubt that credit metrics will deteriorate further” in the third quarter, according to the report. “We would not be surprised to see leverage move back near the crisis peak again” in the third quarter of by the fourth quarter.

Economic Growth

The world economy will grow 3.3 percent this year, the slowest since the 2009 recession, and 3.6 percent next year, the IMF said Oct. 9, compared with July predictions of 3.5 percent in 2012 and 3.9 percent in 2013. The Washington-based lender now sees “alarmingly high” risks of a steeper slowdown, with a one-in-six chance of growth slipping below 2 percent.

Third-quarter profits and sales for companies in the S&P 500 (SPX) probably fell in unison for the first time in three years, according to analysts’ estimates compiled by Bloomberg. Per- share earnings may have dropped 1.7 percent on average after they were little changed in the second quarter. Sales may have slipped 0.6 percent, the data show.

While PIK bonds may perform for a while, “when they stop performing well they become virtually unsellable at times, and they can drop in price rather substantially,” James Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC in Menomonee Falls, Wisconsin, said in a telephone interview.

To contact the reporters on this story: Sarika Gangar in New York at sgangar@bloomberg.net; David Holley in New York at dholley8@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net


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