Watching the debt bubble
Investors who put their money to work in credit markets ask themselves two basic questions every day: How much risk do I want to take, and how much will I insist on being paid for it?
The debt bubble, which has bent all kinds of credit markets out of shape in the last couple of years, changed the usual answers to those questions. Investors began to take on more and more risk, which wasn't a particularly good thing to begin with. Worse, they weren't getting paid any more for their trouble.
The bubble put a practically unknown subprime mortgage market on the front page. It paid for an increasingly risky leveraged buy out boom. It helped boost debt offerings from emerging markets around the world.
But investors who rolled over before are pushing back a bit now, and that would be a good thing. How the debt bubble ultimately unwinds, or blows up, is the single most important issue facing all stock and credit markets today.
Subprime mortgage investors are struggling through tumultuous times, as Bear Stearns Cos. tries to manage a $1.6 billion bailout of its own hedge funds dedicated to the sector. Emerging market debt markets have eased back, though not dramatically, after a five-year run. Bond investors are refusing to buy the least palatable new corporate debt.
It's tempting to connect all those dots, but the picture isn't that simple. Still, investors in all kinds of credit markets appear to be rethinking risk.
Exhibit A: US Foodservice, a unit of Dutch supermarket company Royal Ahold NV, which is being purchased by Kohlberg Kravis Roberts & Co. and Clayton, Dubilier & Rice Inc. Debt offerings to pay for that sale have so far flopped. The latest attempt, offering $650 million in senior notes to finance part of the transaction, was postponed this week.
Investors just said no. The deal piled too much debt on top of the company, and junk bond portfolio managers walked away.
"It's more of a buyer's market than we've seen in a while," says John Addeo , a high-yield portfolio manager at MFS Investment Management in Boston. "I would hesitate to call it a return to normalcy; to date, we've only put the kibosh on a few deals."
What happens later this year will be telling. Debt sales to finance two giant leveraged buy outs, First Data Corp., the world's biggest processor of credit card payments, and Texas utility TXU Corp., are expected. Overall, there is $300 billion of corporate debt offerings anticipated for the balance of the year.
US Foodservice is typical of companies that worry bond investors. There's nothing wrong with the business. The problem is how much money the new owners want to borrow against it.
"I've seen speculative patterns in markets before, and this one clearly has all the earmarkings," says bond fund manager Dan Fuss of Loomis Sayles & Co. "We have a leverage problem. The credits, the companies themselves, are doing quite well."
That speculation has been driven by excess liquidity, huge amounts of global money looking for ways to earn more income.
"Liquidity has the greatest impact, positive and negative, on the riskiest markets," says Ken Taubes , head of US fixed income at Pioneer Investments in Boston.
Taubes sees central banks in Europe and elsewhere raise short-term interest rates, and wonders whether that is beginning to constrict excess liquidity. Higher short-term rates make it harder for some investors to borrow on those terms and then multiply their bets on higher yielding but riskier debt.
The debt bubble could burst and make a real mess, but not necessarily. Corporate junk bond investors demanding better deals are one step in the right direction.
