DELL Dell Inc. (MM)

A spate of recent mega mergers and acquisitions (M&A) appear to be spurred at least partly by the availability of cheap corporate credit. Deals are also driven by the estimated $1 trillion in cash holdings of large companies. Keep in mind that private equity firms reportedly hold an estimated $190 billion or so of unexpended capital which they are eager to deploy. Among negative industry trends, private equity players are finding it tough to sell out and as a result, they are buying and selling portfolio holdings among themselves (tertiary buyouts).

Warren Buffet’s Berkshire Hathaway Inc. (BRK.A) together with Brazilian private equity outfit 3G Capital is on its way to taking over all 56 varieties of iconic H. J. Heinz Company (HNZ) in a $23 billion deal. In a $24 billion transaction, the founder of Dell Inc. (DELL) is de-listing the company with help from private equity firm Silver Lake partners and Microsoft Corporation (MSFT), who will be minority partners.

Then, Comcast Corporation (CMCSA) bid almost $17 billion for the 49% remainder of NBC Universal still owned by General Electric Company (GE). The all-stock merger of AMR Corporation (AAMRQ)and US Airways Group, Inc. (LCC) will create the largest airline in the world with a market cap of $11 billion. Anheuser-Busch InBev SA/NV (BUD) re-submitted a $20 billion offer for the acquisition of Mexican brewer Grupo Modelo, of Corona fame. Finally, there is John Malone’s Liberty Global Inc. (LBTYA)’s takeover of British cable company Virgin Media for about $15 billion in a cash-cum-stock deal.   

Due to contributions from Michael Dell and the company’s substantial cash holdings, Dell will not be as heavily leveraged, post buy-out, as assumed earlier. A consortium of banks, comprising Bank of America Corporation (BAC) and RBC Capital among others, revealed a credit program of about $14 to $15 billion.

Fitch Ratings cut Heinz’s credit rating to junk status as Wells Fargo & Company (WFC) and JPMorgan Chase & Co. (JPM) unveiled a $14.1 billion borrowing program for the company. Heinz and Dell, along with other marquee deals, will increase the supply of high yield bonds (a k a junk bond) in the market.

Companies with investment grade credit quality are also increasingly turning to the corporate bond market for financing. For instance, Intel Corporation (INTC) and Abbott Laboratories (ABT) recently engaged in huge multi-billion dollar borrowings at super-low yields to fund share buyback or other requirements. More companies appear to be skewing their capital structures in favor of debt while maintaining favorable debt service coverage ratios.       

Among supply side issues, high yield bond issuance hit a record last year and the robustness continues. Fund raising companies frequently used the proceeds to refinance higher interest-bearing loans. Then high yield bonds are increasingly being issued by private equity firms to fund their acquisitions. In any case, there is no doubt that the boom in high yield bonds has ensured access to financial markets for even those companies with the lowest credit quality.   

On the demand side, corporate bonds are not just attractive to retail investors. They are also favored by institutional investors, such as insurance companies. In 2012, very low interest rates continued to force yield-starved investors to shift from the safety of Treasuries to more risky assets, such as high yield bonds. The interest in high yield bond funds was so great that some mutual funds, such as T. Rowe Price, even refused to take new investors. Fueled by robust demand, high yield bond yields breached crucial levels and roosted at sub-6% levels late last year. The decline in high yield bond yields noticeably reduced the charges for leveraged buyouts.

Subsequently, the tide changed course in early 2013 such that funds like iShares iBoxx $ High Yield Corporate Bd (HYG) faced redemption pressure for three or four weeks in a row. Consequently, high yield bond fund yields were temporarily back above the 6% mark. Despite the recent minor correction in high yield bond prices, bonds are still ‘priced to perfection’ with a yield to maturity that compares unfavorably with the earnings yield (inverse P/E) of the benchmark S&P 500.

Currently then, high yield bond yields translate into 400 to 500 basis points spread over comparable U.S. Treasury bonds. The risk premium today is on the lower side but not at its nadir. Market mavens still believe that there may be room for shrinkage of the premium.

This bullish outlook is supported by the low default rate for high yield bonds at about 3.2% recently versus the long-term track record of 4.5% or so. The outlook for the default rate is favorable in the medium term although there is some divergence of opinion between Standard & Poor’s Ratings Services – a unit of The McGraw-Hill Companies, Inc. (MHP) and Moody's Corp. (MCO) about its future course. There are some signs of credit degradation with the proportion of credit hikes to credit downgrades turning negative recently.

As for deal-making capability, JPMorgan Chase & Co. is the numero uno among M&A arrangers and The Goldman Sachs Group, Inc. (GS) as another leader. Investment bankers have seen their fortunes soar in line with the growing appetite for high yield bonds, which provides a point of cheer in a season of layoffs on Wall Street. JPMorgan Chase & Co. and Deutsche Bank AG (DB) are just two investment banking boutiques whose high yield arms have done well.

 
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