2012-2014 Debt Wall Probably Won’t Materialise

In 2012 will begin a period during which more than $700B in corporate debt will come due, the hangover from the party of the decade that brought us the largest leveraged buyouts (LBOs) humanity has ever seen. And the private sector isn’t alone – the US government will need to borrow over $2T in 2012. Amid scaled back consumer spending and a tepid jobless recovery, this apocalyptic scenario has prompted Kevin Cassidy, a senior credit officer at Moody’s, to remark that “an avalanche is brewing in 2012 and beyond.”[1]

First a definition; high yield (HY) debt is debt that is rated below investment grade at time of purchase – it has a higher risk-reward blend than debt rated A or higher. It was popularised in the 1980s by Michael Milken at Drexel Burnham Lambert’s Beverly Hills office (read The Predator’s Ball) and, according to Steven Davidoff in Gods At War, set off a wave of debt-fueled buy-out activity that helped create the LBO as we know it today.

The 2012-2014 debt wall scenario makes the assumption that a 2012 HY debenture issued in 2007 will have to be paid off in cash, straining its issuer’s balance sheets, or will have to be re-financed in the same market it was issued in. That is, everyone in a single HY maturity space will be re-financing simultaneously, exhausting demand and driving up yields to levels that many issuers won't be able to afford. I am going to argue that this scenario is implausible due to the chronological locality of HY credit ratings.

HY issuers are different from other types of fixed income issuers in that their credit rating is chronologically local. When IBM, for instance, issued its October 2012 5.05 it was reasonable for an investor to assume that it’s Fitch A rating in October 2007 would probably be true, with little variance, across the bond's lifetime. In other words, the credit rating for mature issuers is chronologically global, similar across the issuance's life. This makes sense if you look at IBM’s position on a growth curve – the point at which it rests exhibits a low first order derivative. This low rate of change begets stability. HY issuers, on the other hand, are a point in the curve exhibiting a very high first order derivative, characterising a high risk/reward deal with significant uncertainty.

For purposes of illustration, let's splice the uncertainty discount for our fictional HY debenture issuer, Acropolis & Co, into the uncertainty for its performance one year after the issuance [0,1]  and the uncertainty for its performance after one year [1, ∞). At the point of issuance, t=0, both uncertainty "reserves" are fully weighing down on the value of the bond. Let's re-visit the company at t=1; assuming the company hasn't blown up, the first year uncertainty reserve should now be zero - its path over [0,1] known at t=1. The [1,2] discount will be less than the [0,1] reserve because it is at a more stable point on its growth curve, implying better cash flow prospects and/or a stronger balance sheet. Thus, [1, ∞) is riskier than [2, ∞). The discount factor should thusly be reduced, with the price rising and yield falling in step.

Let's suppose Acropolis & Co's first debenture was rated CCC at t=0. When issues its new t=1 debenture, the credit rating agencies rate it C. The yield differential between a C and CCC rating are substantial. If the t=0 issue had a call provision, which is not uncommon in the HY markets, it would be in Acropolis & Co's interest to re-finance the t=0 issue with a new t=1 issue, locking in the lower rate. That is, it would pay off the high-interest t=0 issue in full via the proceeds of a lower-interest t=1 issuance. Even if the issue cannot be called, Acropolis & Co will not be in crisis when the bond is due, since it can borrow at its new rate to pay off the principal.

When an issue is re-financed, the new maturity date generally falls after the re-financed debt's maturity. Thus, the 2012-2014 maturity wall should at least be spread over a longer period of time. Additionally, many institutional investors are limited to trading investment grade, that is A or higher, debt. Thus, as issuers approach investment grade, they won't be competing as closely with lower issuers for HY capital, instead having access to deeper waters. The combination of these two trends implies that the 2012-2014 maturity wall has a high likelihood of dissolving away.

This scenario contingent on two things: (1) liquidity in the HY refinance markets at present levels, and, (2) a mild US economic recovery to enable the issuers to continue to service their debt. Additionally, it is assumed that there will be no political intervention in the debt capital markets - that would add a political uncertainty discount factor to the equation, impeding the credit rating rise illustrated above.

A common argument against re-financing is that it simply pushes the problem into the future. But by the process demonstrated above, as the issuers’ interest rates fall and their cash flow positions strengthen, the impact of the debt on the company will fall. Additionally, any new debt will be taken on, as all corporate debt is meant to be, with the assumption of earning a higher rate of return on the cash from the debt than the interest being paid on the debt. Thus, there is a net value add to society overall.

Taken together, the vanishing of the debt wall fares well for the general economy, though no part more than LBOs. Facing mounting piles of dry powder with limited leverage opportunities, buy-out firms have thus far been forced into all-cash deals, pulling down returns. Perhaps a smooth sail through 2012 will relax lenders, bringing leverage back onto the buy-out stage. In any case, it upgrades recruiting prospects for those interested in the debt capital markets or leveraged finance.

Thank-you to Tyler Rives for reading drafts of this.