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Credit Insights

Rising LBO Potential Induces Debt Sell-Off

As M&A activity heats up, many investors have been scouring their portfolios to reduce exposure to companies that could be subject to debt-leveraging transactions.

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The average spread in Morningstar's Corporate Bond Index widened 2 basis points last Monday in sympathy with the sell-off in the equity markets and traded in a narrow range for the rest of the week. The initial bout of fear was driven by the price declines in Italian and Spanish sovereign bonds on news of looming losses in the Italian banking system as a result of derivative trades gone awry and a widening political scandal in Spain. The credit market tried to improve Friday, but the attempted rally seemed to fizzle out early. With the blizzard bearing down on New York, many traders either took the day off or left early.

The long-rumored leveraged buyout of  Dell (DELL) (A+/UR-) was finally officially announced last week, with four banks committing nearly $14 billion in loans to complete the transaction. In addition,
 Liberty Global (LBTYA) (B) announced plans to acquire
 Virgin Media (VMED) (BB-/UR-). As part of the transaction, Liberty will increase Virgin's leverage to 4-5 times earnings before interest, taxes, depreciation, and amortization from 3.5 times currently, adding more than $3 billion in debt to the Virgin capital structure to fund the cash portion of the deal. As merger and acquisition activity is heating up, many investors have been scouring their portfolios to reduce exposure to companies that could be subject to debt-leveraging transactions. As such, the industrials sector widened slightly more than the financial-services sector as prices fell for the bonds of potential LBO targets. Given the regulatory nature of the financials sector, we do not believe there is a reasonable chance that private equity sponsors can structure a leveraged buyout that would effectively subordinate existing bondholders.

In addition to generally improving credit metrics in the banking sector, the absence of LBO activity is one more reason we expect financials to outperform industrials in the first quarter. For additional details on this view, please see our outlook for the credit markets. In addition, we recently published our semiannual Merger and Acquisition Insights, which highlighted issuers that we think are acquisition targets for strategic as well as financial buyers. In the report, we provide an upside/downside analysis on the bonds for issuers that have public debt outstanding. This article summarizes the findings of the M&A research. 

U.S. Banks: Senior Holdco Versus Operating Subordinated Debt

After much wrangling, we think the answer is now clear.
The Washington Mutual bankruptcy created confusion for U.S. bank credit investors. The seizure of the bank operating subsidiary left subordinated credit investors of that subsidiary with zero value. Meanwhile, cash at the senior holding company was trapped and aided holding company debt investors with a respectable recovery. Due to legal and regulatory ambiguity, the process by which the FDIC (and the Office of Thrift Supervision) seized Washington Mutual was different than how many credit investors envisioned the process would go. To correct this, the U.S. government responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act, specifically Title II (Orderly Liquidation Authority). The goal of Title II is to provide the framework for an orderly liquidation of a large interconnected financial company whose failing poses a significant risk to the financial stability of the United States. 

While this legislation has been in place for a while, the FDIC during the past several months has painted a clearer picture of how it plans to act under Title II. This picture leads us to believe that in most cases of a Title II liquidation, senior holding company debt would be treated as structurally subordinate to all the bank operating subsidiary debt. As such, we think that for U.S. banks, subordinated debt at the bank operating subsidiary should trade tighter than, or at the very least the same as, senior debt of the holding company. For simple bank holding structures, we see very little difference between senior and subordinated debt at the bank holding company. If conditions existed where a Title II liquidation would be required, we see the ultimate recovery on both these bonds as most likely zero, making any seniority virtually worthless. This logic, however, fails to hold in a complex structure where there are numerous valuable lines of business under the holding company. For greater detail, please see Jim Leonard's report published last Friday.

Click to see our summary of recent movements among credit risk indicators.

New Issue Notes

IBM's five-year note looks fair, but better value elsewhere (Feb. 5)
 International Business Machines (IBM) (AA-) intends to issue three-year floating- and five-year fixed-rate notes. Initial price talk on the five-year notes is around 50 basis points over Treasuries, which is roughly in line with levels on the firm's existing notes; its 1.25% notes due in 2017, for example, have been trading slightly inside +50 basis points versus comparably dated Treasuries. Given the short duration of this offering and IBM's solid financial and competitive position, we believe that the 5-year notes deserve to trade at very tight spreads and that the initial price talk is fair. However, we see better value elsewhere in the tech industry. Among short-dated issues, we would look at
 NetApp's (NTAP) (A+) 2.0% notes due in 2017, which trade at about 130 basis points over Treasuries. While we don't believe NetApp is as well-positioned competitively as IBM, we believe investors are more than adequately compensated for the additional risk. NetApp competes with significantly larger firms in the storage market, including IBM and  EMC (EMC) (A+). However, the firm generates steady cash flow and has consistently carried far more cash than debt on its books, a position that should enable it to maintain a strong financial profile over the next several years.

Click here to see more new bond issuance for the week ended Feb. 8, 2013.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.