Scared by losses at two hedge funds that invested in securities backed by home loans, investors in securities backed by mortgages, junk bonds, and other assets are demanding more protection for the first time in years.
In the past week investors have balked at buying debt that skirted typical investor safeguards. That's a sharp change from the recent past when demand was high for assets that were priced at historically low premiums over safe-haven U.S. Treasury securities.
The reassessment of risk won't stop private equity firms from tapping debt markets for funds to continue to buy U.S. companies at a record pace, but it will halt more questionable deals in the leveraged buyout market.
It just says that your marginal deals can't get done. That we want to be compensated for everything that's coming down the pike, Justin Monteith, analyst at high-yield research firm KDP Investment Advisors Inc. in Montpelier, Vermont. It doesn't shut down the LBO market.
The re-pricing of risk in the collateralized debt obligation (CDO) market came after losses earlier this month at two Bear Stearns Cos. hedge funds that had made bad bets on subprime mortgages.
Investors have already become more discriminating, demanding higher yields on junk bonds and risky bank loans.
Ahold's U.S. Foodservice, the second-largest U.S. food distributor, withdrew indefinitely its $3.36 billion bank loan and $650 million high-yield bond offering this week. Private equity firms Clayton, Dubilier & Rice and Kohlberg Kravis & Roberts are buying U.S. Foodservice for $7.1 billion.
On Friday, Bombardier Recreational Products postponed a 1.12 billion loan, sources told Reuters Loan Pricing Corp.
Also, ServiceMaster raised interest rates on a $2.85 billion loan for a second time this week and postponed pricing of a $1.15 billion high-yield bond until Monday to secure investor interest, according to Reuters Loan Pricing Corp.
While default rates by less creditworthy borrowers in the subprime home mortgage market may have been rising, there have been no defaults by companies whose credits are behind other CDO vehicles that invest in mortgage, corporate and other asset back debt, said Jeffrey Gundlach, chief investment officer at the TCW Group in Los Angeles. The company manages about $160 billion in assets, including about $47 billion in CDOs.
What's fascinating about this whole subprime thing is that there aren't any defaults. There may be defaults -- certainly the market is pricing for fear of defaults -- but it hasn't even shown up, Gundlach said.
The subprime mortgage market's problems will worsen over the next year, Gundlach said, but there is no rash of margin calls at other hedge funds, so global capital markets are not subject to systemic risk, he added in an interview.
A spectacular collapse by a big hedge fund is unlikely, Gundlack said, but he expected downgrades on some of the assets that TCW owns.
Are there more Bear Stearns? Probably not, Gundlach said. It's just going to stay bad is the problem. There will be selling pressure as risk is re-evaluated and pricing moves lower. There will be ongoing pain.
The U.S. housing market will likely remain in the doldrums for at least another year, but is unlikely to shackle the wider economy, said Margaret Patel, a senior portfolio manager at Evergreen Investments who overseas about $1.7 billion in assets, including high-yield debt.
The impact on the high-debt market is going to be relatively muted and to be felt most in the bottom tier part of the high-yield market, among the more marginal and the more extremely credit-sensitive names, Patel said.
Buyers of the most risky assets who can't liquidate their poor investments may be forced into selling some of their better quality, high-yielding assets, Patel said. That's a buying opportunity for investors, she said.
You have sellers who are selling, not because there's some change in the credits, but just because they need the cash, she said. We've had maybe a little bit of that across the board.
Patel said she's been a buyer recently, as has Carl Kaufman, a portfolio manager at Osterweis Capital Management in San Francisco.
As people panic and shake loose, what you find, sometimes, the names you've had on your buy list for a month and a half, two months, finally get to your price, he said.
Kaufman said he's bought debt of R.H. Donnelley Corp., a yellow pages publishers, at prices yielding about 1.0 percentage point more than last year, yielding between 680 and 690 basis points more than their benchmark.
In fact problems in the CDO market, that critics have pointed to as a sign credit standards have become lax, could be viewed as positive for investors, Kaufman said.
Contracts that use payment in kind toggle notes, which give a borrower the right to pay investors back in cash or more debt, and so-called covenant lite provisions, give borrowers breathing room to work out their problems, Kaufman said.
I'm guessing that this time around, the actual default rate on high-yield bonds peak to peak could actually be lower because there are fewer events of default, Kaufman said.
(Additional reporting by Jennifer Ablan)