December 2, 2007

The case for Shorting Corporate Bonds

I have been talking about the potential fallout from the LBO boom that peaked this summer. The credit crisis and slowing economic activity have increased defaults in housing mortgages defaults and the next shoe to drop will be increased corporate defaults. The bloomberg story highlight John Paulson strategy for profiting from the comping corporate debt crises. He intends to buy credit default swaps on certain issuers, where the swap will pay him in the event of default or price decline of the bond in this case he is shorting the bonds.

Other notable shorts is Pershing Capital as they compare the subprime fallout with LBOs. The hedge fund is shorting the bond insurer MBIA on the premise that defaults on corporate borrowings and structured debt will lead to the demise of the bond insurers earnings and market value.

Do not confuse the recent rally in the financials and mortgages servicers as a recovery. The stock market is in denial on the prospect of more pain to come. Lets look at the facts:

  1. LBOs volume record. LBOs reached a record level of transactions in 2006 ($362 Billion) and were on pace to break that record in 2007 until they got interrupted. Similar to the peak of subprime borrowing in the midst of the housing boom. (Source: JP Morgan)
  2. Relaxed risk pricing. LBOs multiples kept going higher and higher. Private equity kept bidding up prices fueled by liquidity and the urge to do a deal. The multiples for LBO deal went up from 6.1x in 2001 to 8.6x in 2006. Not only prices kept going up so did LBO's leverage. Total debt to EBITDA multiple grew from 4.6x in 2001 to 7.1x in 2006. Housing loans went from traditional mortgages to no money down and interest only mortgages and teaser rates. (Source: JP Morgan)
  3. Housing prices began to drop forcing homeowners that thought to refinance or sell for profit and pay their mortgages to default on payments. The slower economic activity and the disappearance of credit will force many LBOs and highly leveraged operations to default as well. Although currently the default rate of below investment grade borrowers is 1.57% it can jump to 12% and higher. In the last recession of 2001 the default rates doubled from prior year to reach 11%. (source Moody'
  4. Credit for LBOs and corporation all but disappeared from the market, making any refinancing impossible or very expensive. The LIBOR rate, iter-bank lending rate, that measures bank lending is still heading up and in the opposite direction of treasuries and Fed funds rate. The move indicates that banks are tightening their credit standards and untrusting of borrowers balance sheets. Several LBOs were cancelled this summer due to credit markets squeeze, SLM, Herman..etc.
Saying that, shorting is hell of a way to make a return.

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