Markets

Burned by the Fed? Bond Buyers Have an Unlikely Haven

U.S. leveraged buyout loans offer a refuge from Asia’s debt distress.

Leveraged buyouts, as Middle American as apple pie and motherhood.

Photographer: iStock/Getty Images

Bond investors troubled by rising global interest rates and spreading defaults in China may find an unlikely haven in middle America.

Private banks that were enthusiastic buyers of Asia’s dollar bonds in 2017 are feeling burned. The Bloomberg Barclays Asia USD High Yield Bond Index is down 3.2 percent this year, and there are whispers that worse is to come as more cases of financial stress emerge among Chinese borrowers.

Meanwhile, leveraged buyouts are booming in the U.S., and they need funding. So far this year, $356 billion of new loans were originated to finance M&A deals, a 35 percent jump over the same period of 2017 on the back of a series of jumbo transactions, according to data compiled by Bloomberg.

The middle market is the sweet spot. Typically backed by $10 million to $70 million in annual Ebitda, acquisition targets are too small to tap the corporate bond market, and therefore have to offer more to satisfy creditors. On average, new middle-market loans yield 6.68 percent, higher than the 6.4 percent that single-B-rated large issuers pay on corporate bonds. 

Size Matters

Being smaller, middle-market firms are deemed more risky and have to pay more for loans

Source: S&P Global Market Intelligence

Note: A large corporate is defined as one earning at least $50 million of Ebitda annually.

Often, these loans are priced at floating rates, resetting every quarter to reflect changes in underlying benchmarks. In an environment of rising borrowing costs – three-month Libor has almost doubled in the past year to 2.33 percent - they look a lot more attractive than corporate bonds paying fixed coupons.

When interest rates rise, companies laden with debt – typical of those acquired by private equity firms, which use leverage to juice returns – can become distressed. But these middle-market loans are often senior and secured, a world apart from covenant-light corporate bonds. In addition, because of their smaller size, such companies can only borrow only up to five times their underlying cash flow, versus six times or more for larger firms, says Ken Kencel, president and CEO of Churchill Asset Management LLC, a specialist in the space with $4.4 billion of committed capital under management. As a result, default rates are lower. 

Safer House

Middle-market leveraged buyouts are structured more conservatively than large private equity deals

Source: S&P Global Market Intelligence

Note: Data reflect average credit statistics between 2001 and the first quarter of 2018.

So what’s not to like? 

Liquidity is a problem. Investors who place their money with professionals such as Churchill can’t get it back until the fund closes. If they invest directly, these are essentially bank loans that can’t be traded or marked to market like corporate bonds. 

But in this jittery world, the advantage of owning mark-to-market assets may be overrated, especially for wealthy clients at Asia’s private banks. In the past, they could obtain loans against bond investments at a 50 percent collateral ratio; now, lending is being curtailed. One complained to me that one of his high-yield holdings is no longer counted as collateral at HSBC Holdings Plc, even though there has been no market-moving news on the issuer. He is not only nursing paper losses but has had to deposit more money to avoid margin calls.

In these circumstances, a simpler buy-and-hold in the sleepier middle market may be a better option.

And if investors pampered by the average 7.2 percent return on Asian high-yield dollar bonds find middle-market loans aren’t attractive enough, they can always juice returns with a little leverage. 

Juice Up

Asian investors spoiled by the high yields on local dollar bonds' can simply lever up to get the returns they want

Source: Bloomberg

Note: Cliffwater Direct Lending Index tracks investment income of assets held by business development companies, which deploy leverage in their portfolios.

Business development companies that hold middle-market debt offered a 10.08 percent yield as of March, the latest data available.  Those returns will increase after the U.S. passed legislation allowing the funds to increase their maximum leverage to two times equity, from once.

Asian investors are still smarting after being shoveled into SoftBank Group Corp.’s disastrous dollar bonds. Perhaps they should ditch the private bankers and retire to the stability of America's heartland.

 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Shuli Ren at sren38@bloomberg.net

    To contact the editor responsible for this story:
    Matthew Brooker at mbrooker1@bloomberg.net

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