If Fed governor Jeremy Stein had concerns about a resurgent credit bubble in February when he wrote his warning about "Overheating in Credit Markets: Origins, Measurement, and Policy Responses [7]" then he should certainly not look at the bubbly ferocity that is taking place in the bond world just half a year after his letter failed to make any dent in the yield-chasing animal spirits.
For one, as the following chart from Citi shows, median high grade (ex-fin) corporate leverage, is now back to all time highs. Unfortunately, as we forecast last November [8], the bulk of net new issuance is going not toward funding capital spending or hiring intentions, but for capital structure arbitrage, namely funding dividends and buybacks. This means that while the entire IG space has become "equity-friendly" in the pursuit of short-term equity gains (on the back of leverage), the flipside is that there is increasingly less balance sheet room to pay for future growth. And without organic growth, revenues will continue to decline until one day not all the stock buybacks in the world can change the reality that there simply is no top or bottom-line growth in the corporate space.
[9]
An example of some companies which have taken the plunge toward record releveraging, and which as Citi observes, question "if they really need to have “pristine” balance sheets, or for that matter even better balance sheets" are the following.
[10]
That this is happening just as rates have soared higher will hardly be beneficial, or certainly accrual to corporate cash flows or earnings.
And yet the music is still playing, so one must dance. Nowhere is this more evident, than in yesterday's news [11]that as part of its pro forma capital structure, the recently announced re-LBO of Neiman Marcus [12]will contain PIK Toggle bonds. This is the first time a PIK Toggle has been used since the peak of the credit bubble, proving beyond a doubt that the very same dynamics that led to the last credit-funded crash are here, and now.
The acquisition financing for US luxury retailer Neiman Marcus is expected to include a payment-in-kind (PIK) toggle, according to several market sources, the first time this riskier structure has been used in a LBO since the financial crisis.
The bond part of the new capital structure will be a PIK toggle, sources said, which would give the new owners the option to pay interest in cash or allow it to accrue to the principal.
"The only reason that you would include a PIK toggle in a LBO would be if there was too much leverage, and there was a concern that the business would not generate enough cash to pay the interest," said a senior leveraged banker not on the deal.
Three bankers said this was the first time the instrument had been used for a LBO at the operating level since before the financial crisis.
Ironically it was Neiman the trend of PIK Toggles back in 2005 with its first LBO.
During the leveraged buyout boom in 2006-2007, PIK toggles were often used to give companies with weak cash flows greater debt flexibility. In fact, Neiman started the trend, when it was bought out in 2005, it was partly financed with a PIK toggle.
Neiman was able to, and did, stop making interest payments in cash and instead doled out more debt. This option slowed the company's repayment of its original borrowing load of 6.4 times Ebitda, but helped Neiman survive the tough times.
What is Neiman's pro forma leverage expected to be now?
"We decided not to participate in this. It's a great asset, and no doubt it will go fine, but we don't want to be the bank that gets caught out if the market turns," said the banker. He estimated leverage to be in the region of 7.3 times earnings.
Off the bat, the Neiman LBO ver 2.0 is already 1 extra turn in EBITDA more indebted then the last time it was taken private, and when it almost went bankrupt when the entire credit space blew up.
Another senior banker, also away from the deal, described the financing for Neiman Marcus as a top of the market trade.
Well, that, or there is much more upside, all of which however will eventually end up on the balance sheet of the world's largest hedge fund-cum-bad bank: the Federal Reserve. After all, we are long past the point of "all in."