Buying Formerly Investment Grade Bonds of LBO Deals

by: David Merkel, CFA

Here was a reader question from yesterday:

I’ve been reading your blog for awhile, and I appreciate all the hard work you put into it. I especially like how you comment on intermarket relationships, and it’s helping to quicken my ever so slowly growing knowledge of the markets.

I read your comments that higher quality bonds should perform better than lower quality, because of a probable rising cost of capital for lower quality companies. In a different environment, or for financially secure companies, is it ever a good idea to make a leveraged buy of higher yielding bonds, where the bond sells at a discount and the coupon is greater than the margin interest rate?

I realize that junk bonds are called such for a reason, and that if reaching for yield was a no-brainer prospect then everyone would be doing this. But I notice that a company like Alltel with a 7/01/2012 maturity has a 7% coupon and 9.156 YTM, and a borderline investment grade rating. While a lot more research would need to go into a bond before buying, would something like this, in theory, be safely bought with any leverage?

Lastly, is debt issued by companies acquired by private-equity firms worth looking at, or is it to be avoided at all costs?

Thank you very much for any help you could provide, and I apologize for the long length of my email,

Yes, in a different environment, a leveraged purchase of lower quality bonds can be a great idea, though I tend to purchase the equity instead. Starting about the time of the Iraq war, we hit a period where low quality bonds outperformed for four years. Since then it has been tough; it goes in cycles. Typically, the time to buy low quality bonds is when everyone is scared to death, the VIX is over 40, and realized defaults are high. This scares everyone away.

Now, with Alltel, this reminds me of an “Ask Our Pros” question that was asked of me on RealMoney, back when they had that feature. (I think I got asked the most, because of my unconventional skill set, but I don’t know that for sure…) A read asked about Toys ‘R Us bonds. Here’s what I wrote back then:

Toys R Us Debt
4/4/05 7:26 AM EDT

Reader: What do you think of buying debt of Toys R Us (TOY:NYSE) now that they are being acquired, I don’t see KKR buying a company and defaulting on its debt. I am specifically looking at the 7 5/8 2011 trading at about 95. – G.S.

David Merkel: I think you ought to be careful here. Buying the debt of a junk-rated company owned by private investors is not trivial.

Suppose you source the bonds at $95, for a yield to maturity in about 6 1/2 years of 8.66%. The best thing that could happen is that the private buyers turn around and sell Toys R Us to an investment-grade buyer who foolishly decides to guarantee the debt. Less good, but still good, is that the spread compression in the market continues, your bonds get bid up and you sell for a profit. Still less good is that it matures and you make your 8.66%. Now for the bad scenarios.

When the Toys R Us bond in question was issued, it was an investment-grade bond. Toys R Us won’t file financial statements. There are no covenants to protect you. In principle, the private buyers could sell a profitable division like Babies R Us and pay themselves a special dividend with the proceeds. You just lost security as a result. Granted, a case could be made for fraudulent conveyance, but try proving that in the courts against the private buyers’ legal team. Also, you could be structurally subordinated by bank debt at Toys R Us. The private buyers could borrow at the bank with Toys R Us as the borrower and pay themselves a special dividend (if the bank lets them). You now have less security.

Or, they could use the money to grow the business. If things go well, they win big, and you get principal and interest. If things go badly, you both could end up with zeroes, but remember, they are private buyers; they probably got some level of dividends out of the deal. Their objective is to skate on a thin equity base to make the highest return on equity that they can. They don’t care about bondholders, unless they are selling bonds.

Their interests and yours are not perfectly aligned. The spread on the bond is weak single-B, which is fair in my opinion for the risks that you would be taking on relative to other securities like it in the market. Those risks are real, and not ones that I typically like to play.

No positions

With Alltel, you are similarly facing a private equity buyout, which will get done if the LBO debt market normalizes (not holding my breath). It is junk-rated by two agencies, and investment grade by two. Unless the deal fails, it is junk grade, with all of the problems listed in my note above for Toys ‘R Us.

There is a time in the cycle to buy debts like this, but it is not now. The level of panic is too low. Wait until we see significant defaults in high yield borrowers, and then revisit this question. Spreads have widened on high yield names, but not as much as they will when defaults start coming through.

One final note, when the cycle turns, you don’t want to mess around with AT paper maturing in 2012. You would want the stuff maturing in 2029 or 2032. If you’re going to play it, play it to the hilt, but only once the cycle has turned.