For years it seemed nothing could slow down the tsunami of junk debt. Yield-desperate investors, driven to near insanity by iron-fisted central-bank interest-rate repression, were holding their nose and closing their eyes while grabbing the riskiest paper under the crappiest conditions from the bottom of the barrel in their no-holds-barred chase to get a tiny little bit of extra yield.
So last week, French cable TV company Numericable, a subsidiary of multinational cable and telecom company Altice, sold $7.78 billion and €2.25 billion of junk bonds, an all-time record. Insatiable demand allowed the company to sell this stuff at irrationally low yields, given the risks, with some notes yielding as little as 5%. The deal blew past the prior record, Sprint’s sale in September of $6.5 billion in junk bonds. The funds will be used to fund the acquisition of its French competitor, SFR.
That was April 23. But now cracks in the most malodorous corners of the junk debt bubble have appeared.
Investors had gone on a feeding frenzy and poured money into mutual funds that specialize in “leveraged loans” whose “high yield,” if you ignored the risks, made them relatively attractive in the zero-interest-rate environment that the Fed and other central banks have inflicted on the land. These mutual funds, endowed with conservative-sounding names and glossy charts, were marketed to retail investors. And retail investors poured money into them, and fund managers went out to blow it on leveraged loans. Why? Because it was their job.
The buying binge pushed down yields on even the crappiest loans to the level that one-year FDIC-insured CDs paid in saner times before the financial crisis – before the Fed’s machinations converted the credit market into an absurd game in which “high-yield” has become a misnomer.
This feeding frenzy by investors who don’t know what they’re getting encouraged companies to issue a record $355 billion in new leveraged loans last year in the US, according to Bloomberg. This year started out just as hot, with $113.7 billion so far. Leveraged-loan mutual funds saw 95 weeks in a row of inflows, and there was no indication that it would ever stop because the whole Fed-designed machinery itself created insatiable demand.
Private equity firms – the ultimate smart money – have profited from this insatiable demand via an ingenious trick that the infamous dumb-money investors in leveraged-loan mutual funds were never meant to see. PE firms make their already overleveraged, junk-rated portfolio companies borrow even more money, but not to invest in productive projects. Instead, PE firms suck this money out of their portfolio companies via special dividends. A form of immensely profitable financial strip-mining.
When the portfolio company topples under the weight of this debt, those who hold the debt – for instance, the conservative-sounding leveraged-loan mutual fund in your portfolio – have a good chance of losing it all, while the PE firm, loaded with this cash, can be found reminiscing gleefully about the banner year they’d had.
But something happened in mid-April, and investors in leveraged-loan mutual funds ran scared and started pulling their money out. After 95 weeks in a row of money inflows, these funds suddenly saw outflows for the second week in a row, modest still, of $320 million and $160 million respectively. That reversal of the money flow left skid marks: at least three companies pulled their leveraged loans in April, Bloomberg reported; that “insatiable” demand had suddenly evaporated.
Software development firm Rocket Software, which Moody’s rates B2 – five levels below investment-grade, and thus deep into the realm of junk – offered $725 million in loans to refinance some debt and pay a special dividend of $279 million to its owners – top management and PE firm Court Square Capital Partners.
In 2012, Court Square and management had already sucked $260 million out of the company via the same special dividend trick, funded by a leveraged-loan. PE firms are truly the smart money: in 2009, Court Square had invested just $92 million in Rocket’s stock, and these dividends would pay out several times the value of its original investment in less than five years. So it really doesn’t matter if the stock becomes worthless in a restructuring.
But on April 23, Moody’s warned that the “large increase in debt” resulting from the second money-suck operation – though it didn’t quite word it that way – would increase the leverage ratio “above our threshold for a B2 rating.” And so it slapped a “negative outlook” on the company.
It wouldn’t have spooked anyone during the feeding frenzy of leveraged loans. But something has changed. Demand suddenly wasn’t insatiable any longer. And so Rocket had to pull the deal.
WidenOpenWest, the 13th largest cable company in the US, according to PE firm Avista Capital Partners, which had bought it in 2006, had to pull a debt offering of nearly $2 billion in April. And Dutch LLC, whose public-facing brand is Joie, designer and seller of – according to its own words – “understatedly chic” women’s apparel, well, it had to yank a $200 million debt deal.
The first unpleasant whiffs of reality are descending on a seamy corner of the biggest credit bubble in history that the Fed created by printing a few trillion dollars, imposing financial repression via its iron-fisted zero-interest-rate policy, and wringing out the silly idea that investors should be compensated for risk. But now at least some investors are opening their eyes a teensy-weensy bit, and they recoil at what they see, and they fear the losses coming their way.
If more investors let go of their nose long enough to smell those whiffs of reality, the largest credit bubble in history, with all its distortions and absurdities, would be pricked by nothing more than the simple absence of insatiable demand. As always, the dumb money will pay dutifully, but even the smartest money is already getting tripped up.