After a mere $100 billion in projected debt maturities in the 2010-2011 period, the LBO wave of 2005-2007, largely financed with 5-7 year tenor bonds and loans, will set the refi scene on fire in the 2012-2014 period, when $700 billion of debt is set to mature. Should Fed Fund rates, and the yield curve begin to shift higher, the incremental cost of debt capital will destroy tens if not hundreds of billions of equity value over the next 5 years. After peaking at 19.4% in Q4, 2008, and subsequently dropping to 9.5%, Moody's expects HY bond yields to begin increasing in 2011. And while HY companies are rushing to access the current favorable HY refi window, when refi capital is still broadly available, growth capital has been extremely scarce with just 4% of last year's total HY issuance used for M&A activity (78% was for refinancing maturity extension). It would appear High Yield companies have entered "run-off" mode for credit investors, with no consideration for any residual equity value.
In a report titled, Refunding Risk and Needs for U.S. Speculative-Grade Corporate Issuers, 2010-2014, Moody's shares some very troubling perspectives on an upcoming 5 year HY refi cliff. To wit:
- U.S. speculative-grade issuers face more than $800 billion in refunding requirements over the next five years, including $555 billion in bank credit facilities and $250 billion of bonds. About 995 of our 1,300 speculative-grade issuers have debt maturing over this period. The enormous amount of debt due over the next five years stems from a robust period of refinancing and leveraged buy-out activity prior to summer 2007.
- Refunding needs for 2010-2012 are up by more than one-third from the 2009-2011 period reported in last year’s study, to $255 billion—the biggest three-year amount in the history of our 12-year-old study.
- Although speculative-grade companies face only $100 billion in debt maturities in 2010 and 2011, more than $700 billion is set to mature in 2012-2014.
Some more granularity from Moody's:
- While the level of maturities over the next five years may not appear excessive from the historical perspective of high-yield debt issuance, the high-yield bond market’s ability to continue filling the financing void left by banks remains uncertain.
- Certain conditions cast doubt over the markets’ ability to absorb this tremendous debt burden, including lenders’ capacity and appetite, the risk of a double-dip recession or a prolonged period of below-normal growth levels.
- The high-yield bond market was robust in 2009 as investors became willing to take on more risk and were in search of yield with a record dollar amount of $145 billion of high-yield bonds issued in 2009. Speculative-grade issuers raised roughly $200 billion of Moody’s rated debt overall in 2009 (including bank debt).
- Most of the speculative-grade debt issued in 2009—about 78%—went toward refinancing existing debt or extending debt maturities. Only about 4% was used to finance mergers and acquisitions. The remainder was used to enhance liquidity or for general corporate purposes.
- Near-term refunding risk is moderate for rated U.S. speculative-grade companies. Indeed, refunding risk has eased since 2009, with intrinsic and market liquidity improving, the U.S. economy beginning to recover, and expected default rates decreasing.
- Longer-term refunding risk remains a concern amid a tentative economic recovery, continued high unemployment, and interest rates that are likely to increase. More than $100 billion of total debt maturing in 2012-2014 is rated Caa1 or lower.
- Around 67% of bonds maturing in 2010-2014 have instrument ratings of B1 or lower, up from 62% in last year’s study and 53% in the 2008 study. About 32% (valued at $79 billion) have instrument ratings of Caa1 or lower, compared to 29% ($26 billion) in last year’s study and only 22% ($8 billion) in the 2008 study.
- Ratings quality deteriorated for both bank credit facilities and bonds compared to last year’s study—a fact that could exacerbate the banks’ continued caution in post-downturn lending. However, in the latter part of 2009, overall ratings quality began to show positive trends as both the upgrade/downgrade ratio and the number of companies on review for downgrade improved.
Keep in mind the HY maturity cliff is not an isolated phenomenon. It is coupled with increasing roll requirements in the US Bond curve to the expressed need by the Treasury to push the average maturity further, meaning that not only will there be roughly $1.6 trillion in new net issuance, but the refi rotation out of Bills into Notes and Bonds (due to physical constraints as ever fewer Bills will be made available) will make not only general refis more difficult, but the prevalent interest rate on debt that much higher. A useful chart demonstrating the ever widening yield schism between near-dated govvies (under 2 years) and long-dated securities can be seen on this presentation from the Atlanta Fed:
The persistent demand for Bills is all too obvious as despite all posturing, investors still flock to the "safety" of the ultra short-term end of the curve, even as the longer-dated offerings are increasingly perceived as threatened by inflation. This has manifested itself recently in an all time record steepness of the 2s10s and 2s30s, a phenomenon which continues to transfer "free" taxpayer money to banks which borrow near and lend far, from the Federal Reserve which in 2009 was the de facto marginal player in the UST and MBS markets.
So, to recap what we know, once again:
- Previously we have shown estimates which put the Financial Company maturity cliff at $7 trillion by 2012 and $10 trillion by 2015.
- Furthermore, we know that with 40% of the $7 trillion in marketable government Bonds maturing in one year or less, the US Treasury, each and ever year, will need to refinance about $3 trillion in gross debt, all this excluding incremental refinancings (net new issuance which as has been shown will be at least $1.6 trillion in 2010).
- $1.4 trillion in commercial mortgages matures by 2013
- Thanks to Moody's, we now know that there will be nearly $1 trillion in HY maturities by 2014.
- And all this ignores refinancing needs by Investment Grade companies and municipal debt. Our focus next will be to estimate the impact of IG refis over the next 4 years, which we tentatively estimate will be in the $2-4 trillion range.
So as others deal in philosophical ponderings about the state of the economy and whether or not Goldman Sachs did or did not rape AIG (it did - how many times does it have to be said? And it very likely did so in a questionably legal manner- here and here), we ask the all too practical question: in a rising interest rate environment, where will the roughly $13-15 trillion in capital come from to fund refis the coming refis? Certainly, should all this debt be put to the companies, there is nowhere near enough cash to see the refunding of trillions and trillions of new money. And from the creditors standpoint, just what interest will be demanded once it daws upon investors that debtors have no other choice but to acquiesce to any interest demands as the alternative is insolvency? Certainly the Federal Reserve is all too aware of this. We ask how, with a market that has already internalized the $1.7 trillion in QE market manipulation, will Bernanke let this ridiculous amount of money be allowed to be sorted out solely between private hands? The Fed will have no option but to get back in the debt (and therefore equity) market sooner or later.
Back to the High Yield discussion. Even Moody's is not certain that there will be sufficient interest in the market to take down this massive refi cliff:
An avalanche of U.S. speculative-grade, non-financial corporate debt—more than $800 billion—is scheduled to mature during 2010-2014. Not surprisingly, questions are growing over the markets’ ability to handle this debt.
An examination of 995 U.S. speculative-grade non-financial corporate issuer families, encompassing 1,471 bank credit facilities and 995 bonds, shows that $21 billion comes due in 2010, $79 billion in 2011, $155 billion in 2012, $212 billion in 2013, and $338 billion in 2014.
The $255 billion maturing between 2010 and 2012—which is 34% more than the $190 billion for 2009-2011 shown in last year’s study—represents the largest refunding need we have seen during the 12 years of our annual study of refunding needs and risk.
Immediate refunding needs are relatively modest, with just $21 billion maturing in 2010 and $79 billion in 2011—a welcome relief just as the economy begins to recover. But the big refunding needs in 2012-2014 of more than $700 billion poses a substantial concern, given the uncertain state of the banking industry, a national unemployment rate that we expect to reach 10.8% by October 2010.
We also note that 40 former investment-grade companies, with more than $80 billion of debt, were downgraded to speculative grade during the recession of the last two years. The largest “fallen angels” were Weyerhaeuser, J.C. Penney, Sprint Nextel, Masco and Harrah’s Entertainment.
The chart below demonstrates the sudden dramatic hiring interest by hedge funds in TMT analysts: of the top 10 issuers with the largest proportion of maturities in 2010-2014, Telecom/Media/Technology accounts for 4 out of 10 deals. (The unmitigated disasters of the TXU LBO and the Calpine bankruptcy certainly add some flavor to this list, so energy analysts don't despair, you will also be needed. Everyone else, tough luck).
The primary reason for concern when looking at the refi cliff: the lack of CLO resurgence.
The increase in the number of CLO investors in the mid-2000s is a major factor for the daunting size of refunding needs over the next five years. However, the speculative-grade debt market dynamic changed considerably during 2009, as the leveraged loan market—the main engine for funds until October 2007—dried up. Meanwhile, the high-yield bond market, which took a backseat during the leveraged buy-out (LBO) boom, has seen rapid growth in 2009 and the question remains whether the bond market can continue to fill the void left by the scale-back of the leveraged loan market especially since refunding needs over the next five years are still heavily weighted toward bank credit facilities.
One reason loan volumes decreased during 2008 and 2009 was that the largest players in the market, the CLO investors, were not able to access financing and were forced to exit the market. In the first quarter of 2007, 67% of the leveraged loan market was dominated by institutional investors, including CLO investors. By the fourth quarter of 2008, the share of institutional investors dropped to 5%. Since bottoming out in the fourth quarter in 2008, we have seen a steady increase in the share of institutional investors in the leveraged loan market. By the fourth quarter of 2009, the share of institutional investors stood at 28% (see graph below). However, compared to 2006 and 2007, the number of institutional investors remains extremely low.
Will the market burp or will the refis cause a case of toxic loan food poisoning?
The sheer volume of debt maturities between now and 2014 is a concern, and raises questions about the markets’ ability to absorb so much debt. Data from Credit Suisse show that the leveraged loan market debt issuance peaked at $689 billion in 2007, and fell to just $239 billion in 2009. FIGURE 9 The 10-year average of annual new leveraged-loan deals is about $390 billion (around $330 billion, excluding 2006 and 2007).
As it happens, new high-yield bond issuance increased significantly from $49 billion in 2008 to $145 billion in 2009. The high-yield bond market has averaged around $95 billion annually over the past 10 years (issuance during 2006 and 2007 does not meaningfully change this amount). Thus, the combined 10-year average of new speculative-grade issuance for both bonds and loans was approximately $485 billion (or $425 billion excluding 2006 and 2007).
When comparing the 10-year average issuance rate of speculative-grade securities to 2014’s peak refunding needs of $338 billion, it seems possible that the market can absorb the upcoming maturities—as long as the U.S. economy as well as the high-yield bond and leveraged loan markets continue to recover.
Beyond refinancing, however, it remains to be seen whether companies can tap the market for growth capital. About 78% of the $200 billion or so of speculative-grade debt issuance during 2009 was directed toward refinancing existing debt or extending debt maturities. Only about 4% went towards M&A activity. Companies used the remainder to enhance liquidity or for general corporate purposes.
The key threat, as presented previously, rising interest rates, and the distinction between market-refunding risk and company specific refunding risk:
As the scale of refunding needs grows in 2012-2014, the potential for rising costs of financing could become an issue for speculative-grade debt issuers. Yields for high-yield bonds have declined substantially since the fourth quarter of 2008, when they peaked at 19.4%, to roughly 9.5% one year later. Yields are expected to continue decreasing in 2010 to about 8.7% in the fourth quarter. But these yields could increase in 2011 and continue rising in 2012 and 2013. As the volume of debt maturity expands in 2012-2014, with maturities of $155 billion, $212 and $338 billion, the potential for higher yields could become as important as the size of the maturities.
Overall refunding risk has two principal components: market refunding risk, and company-specific refunding risk. Over the near-term, refunding risk—defined as market conditions and company-specific ratings and liquidity over the next 12 months—has eased considerably, compared to late 2008 and early 2009. The reduced pressure stems from a slight improvement in the economy and an improvement in market and company-specific liquidity. The pace of downgrades and companies placed under review for downgrade has begun to slow as well. But the fragile state of the U.S. economy and many other factors make refunding risk a greater concern over the medium- and long-term.
While we believe market refunding risk has eased from last year, it remains above normal levels, due to the weak loan market and uncertain economic conditions.
On the other hand, company-specific refunding risk has deteriorated for both bank credit facilities and bonds, compared to recent years given the higher refinancing needs of lower-rated companies. However, we expect the company-specific refunding risk to ease as the U.S. economy has begun to recover, and liquidity has improved since late 2008 and early 2009, both in the lending market overall, and for individual companies’ balance sheets. The pace of downgrades and the number of companies now on review for downgrade started to slow at the end of 2009—a sign that the worst of the economic downturn could be over, at least from the credit perspective.
But longer-term refunding risk (both market and company-specific risk) remains a concern. The sustainability of the burgeoning economic recovery still looks uncertain, unemployment remains high, and interest rates are likely to increase. Moreover, ratings have deteriorated: more than $100 billion of speculative-grade debt due in 2012-2014 is now rated Caa1 or lower.
Breaking down the rating profile by maturity date yields the following charts - those Caa1 issues are not looking too hot:
Moody's cautious conclusion, which rests entirely on the pereptuation of the Alice in Wonderland economy we have entered:
While certain conditions have eased over the past year, refunding risk still faces huge uncertainties over the next five years. The sheer volume of debt due to mature in 2010-2014 will continue to raise concerns about the market’s ability to absorb this wave. More than half of this tower of debt—$550 billion of a total $805 billion over this five-year period—comes due in 2013 and 2014. And while issuers’ credit ratings are on the mend in general, the level of maturing debt from low-rated speculative-grade issuers has also been climbing. How the markets avoid being overwhelmed by this onslaught of debt will depend on a number of factors in 2013-2014 that cannot be predicted today, including the strength of the U.S. economy, the prevailing interest rates of the day, and the credit markets’ appetite for speculative-grade debt.
All we can add to Moody's conclusion is that the HY refi cliff is not a phenomenon in isolation and has to be analyzed in tandem with all other sectors of the fixed income market that will need to find a means of extending maturities, or else paying down principal, which is a no go as there is not nearly enough capital to satisfy the amount needed to fund the trillions in maturities. It is this observation that leads us to believing that the implications of the Fed's monetary policy will be substantially more amplified than anyone so far comprehends, as while the $6 trillion MBS market is big, the only downside there is cheaper houses and a loss of household wealth which in either case is imaginary. Yet a creep in interest rates higher will make refinancing an ever greater problem for a vast preponderance of both IG and HY firms, not to mention financial firms and the US government itself. The default avalanche will certainly pick up where it left off in April of 2009 before the Fed decided to singlehandedly become the bidder of only resort in the fixed income market. If this ends, as expected, on schedule in March of 2010 all bets are off. Which is why Bernanke will never let it end.
Full list of upcoming maturities by issuer compliments of Moody's: