The recent turbulence in global markets and the woes of the US subprime mortgage market have refocused investors on investment risks. Glenn Reynolds, chief executive and co-founder of CreditSight, an independent credit research fiirm, responded to readers’ queries on the high-yield bond market, emerging market funds and private equity.
Q: Is the high-yield bond market fundamentally overvalued?
A: We say yes…Whether it is too much money and too many originators going after subprime loans or going after high yield deals, the end of this story is hardly a new one in historical perspective. The “deal too far” gets done, the underwriters dance a little too close to the fire on the quality of the asset brought to market (the “we are all big boys” rationalization) and then the market gets set up for a re-pricing of risk on some event or series of events. With default rates down near historical lows, the direction of the next trade is pretty clear. The incubation period for the usual post-CCC-wave nightmare has been perhaps artificially extended with the boom in global liquidity.
Q: Does the increase in the proportion of lower rated debt mean we are necessarily headed for a big spike in defaults?
GR: Typically during boom periods of high yield you get a spate of marginal issuers coming to market that wouldn’t normally get financing. The classic example of this from the last boom is Iridium, the satellite company which issued debt into the market during the heyday of the mania for anything technology or anything wireless. That company ended up going bust and returning only cents on the dollar to the bank creditors even as litigation waves tortured underwriters throughout. This is obviously an extreme example but if you look at the shape of cumulative default curve for CCC-rated companies, it is steepest in the 3-7 years. This suggests to us that if credit markets do start to tighten, we should start to see a tick up in default rates and in less investor-friendly workouts.
Q: Is there a significant difference between what you see in the cash and derivatives markets in high yield, or crossover?
GR: As the high yield market is usually dollar based and less sensitive to spreads over LIBOR and more granular with smaller cash issues (and thus less liquidity) than investment grade, we have noticed that the basis (the credit derivatives spread minus the LIBOR spreads of the cash bonds) tends to be more negative — i.e. cash bonds are cheap in many cases versus credit derivatives as a rule. We would expect this to gradually correct as the high yield CDS market matures and the significant differences are arbitraged out by the market. An exception to the negative basis trade during a period of heightened volatility would be some of the liquid fallen angel names such as the US auto names.
Q: Is this a good time to invest in a highly diversified emerging market fund? Is it too late to “buy low and sell high”?
GR: Our view is that most of the value has been squeezed out of a lot of the emerging markets over the last year or two, and now is probably not the best time to put a lot of fresh money to work in the sector. Many EM countries have seen important improvements in their fundamentals over the last few years, so we do not expect emerging markets to suffer a full-blown crisis in the immediate near term. There are pockets of overheating and overlending in a few of the major emerging markets countries, however, and we do not think investors are being adequately compensated for those risks. Over the very long term the emerging markets will probably continue to deliver healthy returns, but the volatility in EM should steer most investors to gradually build up exposure rather than investing in EM all at once.
Q:What in your view is the impact of private equity to financial institutions and the financial industry as well. Does private equity have the muscle to reshape the global financial sector, totally eclipsing the status quo?
GR: In short we see the private equity wave as reshaping the status quo and nature of the institutional investor asset allocation process, but not eclipsing the status quo. After all, the status quo structure also provides the take-out bid for the deals later. So the private equity players are in the end pretty dependent on the current global structure of the exchanges to take their profits. Those exchanges may be configured differently in future years and in terms of who wins by region (London vs. New York is always a fun debate), but in the end that is the system that the private equity players themselves are leaning on as well.
In terms of the current “global bulge,” we do not see that as changing all that dramatically either in that regard. Someone still has to provide backstop financing, distribute and disintermediate the risk, provide counterparty lines and financing, and they will be in there taking their slice of deals through their merchant banking wings just like they always have. The menu may change, but the same group of chefs will be doing the cooking.
There is no question that the soaring base of private equity investors and readily available supply of bank loan and high yield credit have fostered a very favourable backdrop for this base of funds to drive a lot of deal activity. That said, the continuation of record deal size and hitting all-new records for deal totals still is somewhat tied to a benign liquidity backdrop, a favourable yield curve, and robust credit fundamentals. That may hardly be the case by 2008, and the ability to drive a hefty deal flow may not be anywhere as favourable as it is now. Right now we are seeing a confluence of very favourable conditions for private equity deals. The best asset class out there right now with the flat-to-inverted curve and solid demand for credit is a leveraged 1st lien loan, not an investment grade corporate bond with weak covenants. That has prompted an asset allocation shift in the marketplace that has fuelled the recent wave. Add a recession, a steep curve and tighter credit (tighter in liquidity, structure, and less generous pricing), and people will see deal flow altered dramatically. In fact, more leveraged funds will be back in the distressed business by then, and more private equity funds will be as well.
http://ftalphaville.ft.com/blog/2007/03/20/3263/ask-the-expert-investment-risks/
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