Source: The Wall Street Journal
 
Despite a long-held anxiety that companies soon will find borrowing money tougher, conditions in the corporate-debt market are as friendly as ever.
 
Long-term interest rates remain cheap and credit defaults are rare. Low-quality corporate bonds are trading like they are almost risk-free with very low yields, and investors are loaning money to companies with few constraints.
 
But these blissful conditions are prompting rising concern among some veteran analysts about a possible bubble, fueled by a still-easy monetary policy, despite 14 consecutive short-term interest-rate increases by the Federal Reserve since June 2004. "The Fed hasn't done much," says William Dudley, an advisory economist for Goldman Sachs Group. "Overall financial conditions are much easier than in 2002."
 
The corporate-debt market reflects the same desperate search for yield that has sent investors looking for deals in everything from timber to Tajikistan shares. "Risk and return are all out of whack," says Dan Toscano, head of loan syndication at Deutsche Bank. "People are taking the riskiest pieces of the corporate capital structure even though they are not being paid to do so."
 
Even as many analysts warn of excessive optimism, the corporate credit markets grind ahead. "These conditions are like the Nasdaq at 4000," says Marc Freed, a managing director at Lyster Watson & Co. in New York, which invests in hedge funds on behalf of its clients. "And then, [the Nasdaq] rose to 5000 before correcting. As time passes, credit committees lose influence as their forecasts of imminent doom fail to materialize. It is the fate of credit people to be viewed as Cassandras."
 
The friendly environment has given rise to more borrowing. Private-equity firms, which invest in businesses with the hope of ultimately selling them or taking them public at a healthy profit, are increasingly active, piling up debt, or leverage, on their portfolio companies.
 
"We see leverage creep everywhere. We see companies with very high leverage, and they can still raise another turn of leverage when they already have business issues," Henry Miller, head of Miller Buckfire & Co., a restructuring advisory boutique in New York, told a recent conference. "In the old days, banks did not do deals for such poor companies."
 
In the past, banks strongly encouraged conservative capital structures. But that is no longer the case. "Banks used to want to see you be more conservative," says Daniel O'Connell, chief executive of Vestar Capital Partners, a major private-equity firm. "Now they encourage us" to borrow more.
 
The banks are more aggressive because they rarely keep the loans they make. Instead, they sell them to others, who then repackage, or securitize, the loans and sell them to investors in exotic-sounding vehicles, such as CLOs, or collateralized-loan obligations. Every week brings announcements of billions of dollars in new CLOs, created by traditional money-management and hedge funds, which then sell them to other investors. In many cases, they may keep some slices of these complicated securities.
 
Private-equity firms understand the market because they control about half of the lower-rated companies that are issuing the debt these days. They use their clout to get better terms, which means fewer and fewer constraints on their debt issuing.
 
Late last year, for example, Texas Pacific Group and Warburg Pincus went to the bank market for $1.975 billion to finance their purchase of upscale retailer Neiman Marcus in a "covenant-lite deal," or one that was free of customary lender restrictions. This year, cinema chain AMC, which also has private-equity owners, raised $650 million in another covenant-lite deal. Such deals "will catch fire in 2006," predicted Standard & Poor's analysts in a recent report.
 
Demand from funds that create CLOs, especially hedge funds, means the market can do ever-larger deals, such as the record financing for Koch Industries' buyout of Georgia Pacific, which involved no bonds and $11.25 billion of bank loans.
 
The main concern, though, comes from the fact that the CLO funds buy loans that the banks arrange largely with borrowed money. For example, to create a $500 million CLO, a fund will take no more than $50 million of its own money. The remaining $450 million is borrowed. All is well as long as the companies whose debt is in the structure pay off their obligations.
 
But at some point, some of them will default as interest rates rise and economic growth slows or they encounter some challenge to their business. And these are companies that begin life with a lot of debt, which gives them little flexibility to cope with a more hostile environment. When debt-ridden companies stumble, the whole structure could seize up because the fund still has to pay interest on that $450 million it borrowed to create the CLO.
 
As long as there is a lot of money sloshing around, as is the case these days, the landscape will remain benign. But this flow of money can turn on a dime. And when it does, there will be fewer signs, thanks to the lack of covenants, which historically function as a sort of early warning system. And because investors are using borrowed money to invest, they will have less margin to weather the storm as well.