Corporate credit markets look frothy

By Sober Look

This summer’s growing fears of the Fed’s impending policy change hit a number of fixed income sectors quite hard. While corporate credit was the best performer on a relative basis, it too was hit by some sell-off and a decline in liquidity. In September however an event in the bond markets brought investors back. Verizon’s massive bond sale went so well, the whole investment grade universe perked up.

FT: – Verizon sold $49bn worth of bonds in a combination of fixed and floating-rate debt spread across six maturities that ranged from three to 30 years. The bonds jumped in secondary markets, rewarding investors who bought the securities at discount prices. The gains generated up to $2bn in profit for investors on the bonds in 24 hours, analysts estimated.

Verizon’s successful sale helped end the summer sell-off and paved the way for an upswing in the market for US corporate bonds. The Fed’s decision later in September to keep its bond-buying programme in place added a new enticement to corporate borrowers as well as investors in fixed income assets.

“There were talks earlier this year about a ‘great rotation’ out of fixed-income and into other asset classes,” says Alex Gennis, a credit strategist at Barclays. “Indications point to a very strong and healthy appetite for paper in the corporate bond market. The ‘great rotation’ has yet to happen.”

As the equity markets resumed their rally, corporate spreads – including high yield – began to tighten again. All of a sudden we find ourselves back in the frothy corporate credit environment that existed before the Fed struck a more hawkish tone in May (see discussion).

SFGate: – The extra yield company bonds offer over Treasuries approached the narrowest level in six years as Federal Reserve Chairman Ben S. Bernanke said interest rates will stay low and investors sought ways to boost income.

Even within the middle-market credit space, pricing is looking quite rich. BDCs (public investment firms that focus on middle market debt – see discussion) have seen a nearly 60% total return over the past two years. In order to keep paying the same dividend they have been historically, BDCs are increasingly reaching for yield, flooding credit markets with more capital.

Perhaps some of the more publicized signs of corporate credit markets overheating have been the loosened underwriting standards in the syndicated loan market. The so-called “cov-lite” loans often limit the lenders’ ability to take corrective action with the borrower when the company takes a turn for the worse. And the number of such deals has reached new highs.

Just as in the past, eventually someone will be suing the banks for selling these products. We will hear institutional investors testifying in court on how they were mislead by unscrupulous bankers about the “hidden” risks. And some shareholders will be complaining about the amount of leverage the lenders put on the company. Everyone will all of a sudden develop amnesia about how these assets ended up in their portfolios in the first place. And those with capital and the ability to work out distressed situations will make a fortune.