2.09.2011

I'm Ringing the Bell

A little less than a year ago, I came up with an interesting paradigm as it relates to risk, or the absence thereof, in the leveraged finance market:

"When investor demand is so strong in the leveraged loan and high yield market that second lien dividend deals are being oversubscribed, it is time to start selling"
Looking through my inbox the last couple of days, a number of truly fascinating email subjects have scrolled across my screen:
  • "Florida East Coast Railway completes PIK toggle dividend" - LCD, 2/9/11
  • "Credit Suisse High Yield Index at All-Time Lowest Yield: - CSFB, 2/9/11
  • "Pricing bloodbath unfolds in February amid repricings, recaps, refis" - LCD, 2/9/11
  • "Datatel sets launch tomorrow of $430M recap loan" (Discusses DataTel's first and second lien dividend recap) - LCD, 2/2/11
  • "Jan '11: Reasons to Be Skeptical About HY Bubble Talk" - Banc of America, 2/1/11
  • "Yankee Candle notes price at 98 to yield 10.8%" (Discusses Yankee Candle's dividend deal to sponsors issued at its holding company) - LCD, 2/4/11
  • "Distressed Buyers Seek Stocks as Debt Bubble Looms, Survey Says" - LCD, 1/26/11
  • Etc / Etc / Etc
Further, you are seeing a fairly ominous trend in the leveraged loan side of the market:


Source: Randy Schwimmer's "On the Left"

Admittedly, these types of environments can feed on themselves for a few months. With that said, you are seeing an ACCELERATION of pricing, terms, and leverage degradation over the past two to three weeks that has left me speechless.

What is driving this? After the treasury curve whipsawed many investors around in the 4th quarter of 2010, everyone started looking for cheap inflation hedges. Bank debt is one such hedge. Consultants starting telling endowments and pensions, advisors starting telling their clients, culminating with this chart:

Dealers will do whatever they can to convince investors to stay bullish. Clients bullish leads to more demand for products which means more investment banking fees (financing, advisory, M&A).

In that, I'm going to ring the bell and say we are deep inside a credit bubble. I do not know when it will burst - could be in a few months or later in the year. And I can't tell you what's going to be the catalyst for the move downward. I remember in late 2006 talking to a strategist at a large bank asking: "Everyone around this table knows things are crazy. What's going to stop it?" His answer: "I think we are in a new paradigm of investing that should lead to years of positive risk adjusted returns." Turns out two Bear Stearns hedge funds and the collapse of the RMBS market was the culprit.

Right now, investors are in no way getting compensated for the risk they are taking in credit. There are much better investments out there in certain parts of the equity market in my opinion (long and short).

A smart man once said "Be fearful when others are greedy and greedy when they are fearful." There is no fear in the credit markets now, investors are stumbling over themselves to get allocations - greed as far as the eye can see. Proceed with caution.

11 comments:

Anonymous,  2/09/2011  

I fully agree. I can't believe the types of deals and refinancings that the buy-side are allowing. This market is a mirror image of 2007 / early '08 all over again.

I don't understand how institutional investors feel comfortable paying management fees to these bank loan funds. The PMs do no leg work in analyzing credit agreements or performing fundamental analysis. They just clamor for as much paper as they can get

Anonymous,  2/09/2011  

Plus... they're all scared of the sell-side. It's high time the buy-side comes together and starts pushing back on the i-banks.

Anonymous,  2/09/2011  

The smart man happens to be Warren Buffett..

Anonymous,  2/09/2011  

Maybe frothy at corporate level, but far from bubble yet.

Anonymous,  2/10/2011  

There is plenty of fundamental analysis going on in some places. My shop is shooting down leveraged loan deals left and right, but frequently going in on deals to flip them back in a hot market. Why? B/c we have cash to put to work due to refis and paydowns. Cash kills equity returns.

The buy-side will never come together in a consistent manner b/c it is too fragmented and is driven by the need to put cash to work. The banks are in control by nature b/c they are the gatekeepers. Allocations are very important to buy-side PMs and allocations come from relationships.

I agree with a previous post that says it's frothy (Ply Gem @ 8.25% srsly?), but not a bubble yet. Spreads can still come in further before we get to bubble territory.

Anonymous,  2/10/2011  

Of course the banks are in control. But if the buy-side were to come together and say: "enough is enough. We will not commit to any deals that lack covenants" then by nature the banks will be forced to add them back-in or else they will be stuck holding the paper.

Anonymous,  2/10/2011  

Hunter, what plays do you like on the equity side?

haris07 2/10/2011  

CLO tranches are also in a bubble...structured credit has been on a monster run especially since Dec 2010 (I know because I invested in the junior tranches since Q4 09). Now, too rich and I am looking to sell.

Shaun,  2/10/2011  

you know when high quality GO muni bonds trade at higher raw yields than BB rated corp bonds the institutional demand for yield has gotten out of hand, outside of the occasional special situation, I haven't seen value in high yield in months

sanjita 2/10/2011  

http://edocket.access.gpo.gov/2011/2011-2991.htm

What is this docket document referring to? Can anyone explain? Does this help Tronox to re-organize. I'm not a lawyer or anything. Your thoughts in layman terms would be much appreciated.

AJ

Anonymous,  2/10/2011  

Are there any publicly traded indexes that you can bet against the HY/leveraged loan index that are relatively liquid or have long-term put options? I know of JNK, for example, but I think you would have to cover the dividend if you short it.

Email

hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.