Unintended Consequences for Bond Market Liquidity

Regulatory changes under the Dodd-Frank Act designed to reduce the risk of another financial market downturn may have the reverse effect so suggests an article in “FierceCFO”, the online magazine.

My takeaway from the article is that new regulations forcing large banks out of proprietary bond trading and concentrating it in the hands of hedge funds will increase the risk of illiquidity in the event of another period of instability.

The article suggests that in the event of another period of economic uncertainty, hedge funds will quickly step away from the market accelerating illiquidity.  Regulators have much less leverage over hedge funds to maintain some level of liquidity than they have over the banks.

Click here to read the article on “FierceCFO”.

“FierceCFO” article summary

Liquidity: How regulators are fueling the next crash

We’re not fans of deregulation, but the opposite does have unintended consequences. And TABB Group just released a report that suggests the changes brought about by Dodd-Frank and other regulatory moves made in response to the last financial crisis may set the stage for the next one. How so? By shifting bond trading from banks to hedge funds, which have more freedom to pull in their horns just when the market needs the opposite. In other words, liquidity could dry up at just the wrong time. The money quote comes from Colin Teichholtz, co-head of fixed income trading at Pine River Capital Management: “These new liquidity providers can just turn off the machine in bad times,” Teichholtz said. “Illiquidity can beget illiquidity and there is no obligation on these players to make market. The danger is that the dealers won’t be around to pick up the slack. The optimum business model won’t be to warehouse risk.”

In an interesting development on this topic, Liquidnet, an equity trading “dark pool” is expanding into bond trading to provide an additional trading venue for the bond market.  As the article above stresses, the trading activity conducted by hedge funds through “dark pools” can dry up at any time if parties step to the sidelines.

Click here to read the article on FierceFinanceIT about Liquidnet entering bond trading.

 

European High Yield Bond Spreads Return to Lows

SpreadsChart

 If your company qualifies for raising high yield debt, the European market may be a receptive market.

The spreads on European high yield debt are approaching the lows seen before the financial turmoil in 2008.

This may prompt European companies which had pursued a conservative strategy over the last 5 years to become more expansive with the availability of lower cost capital.

Similarly, low cost capital may spark an increase in acquisitions by both companies and private equity groups.

Click here to go to the website of the Federal Reserve Bank of St. Louis for background on the BofA Merrill Lynch data.

High(?) Yield Bonds

Dennis McCarthy – (213) 222-8260 – dennismccarthy@ariesmgmt.com

New high yield bonds are now being issued at interest rates that don’t really qualify as high.

Forbes magazine reports that the 30-day average high yield new issue bond yield fell to 6.11% at the end of January.

If your company has debt outstanding in an amount of $100 million or more, your company should consider issuing high yield bonds at these historically low rates.

Many companies continue to borrow at short-term floating rates because those rates are amazingly low. Most likely, short-term floating rates won’t stay this low for 5 to 10 years, however. 

In contrast, today’s high yield bond rates present an opportunity to lock in low rates for a long period.

Also, short-term floating rate debt typically carries covenants that restrict a company. 

Again, in contrast, high yield bonds typically have very few covenants restricting the issuer. 

Please contact me to discuss raising high yield bonds or any capital market transaction.

Forbes article link: http://www.forbes.com/sites/spleverage/2013/01/22/high-yield-bond-yields-hit-record-low-6-11/

high-yield-bond-yield

Flood of Corporate Bonds

Dennis McCarthy – (213) 222-8260 – dennis@monarchbayassociates.com

Right now, corporations are raising capital in record amounts by selling high grade bonds.

Can you blame them?  High grade corporate bonds are priced today at record low interest rates.

Even at these record low yields, investors are buying corporate high grade bonds in large volumes.

Investors are seeking interest rates that offer positive yields over inflation. 

The traditional source of yield for many investors, US Treasuries, seems no longer attractive.

 So, what’s the take-away here. 

You should at least consider raising capital through issuing corporate bonds if your company could rationally raise debt of roughly $100 million or more.

Contact me to discuss raising debt to capture this opportunity, or any capital market topic. 

www.lockinlowrate.com

 

Interest Rate Risk – “Preaching to the Choir”

Dennis McCarthy – (213) 222-8260 – dennismccarthy@ariesmgmt.com

“Preaching to the choir”.  In this case, the choir is me.  It seems that every commercial banker I meet, tells me to advise my clients, or anyone who’ll listen, to lock in today’s low interest rates.

When I ask, “what’s the risk?”, I get a lecture that we’re in an interest rate bubble and that despite the Fed’s announcement about the Fed Funds rate, business loan rates will likely rise, especially after the election.

When I confess that I not only believe them but share their concern, I ask “what should a company do to lock in these low rates?” 

Since most companies have floating rate business loans, the bankers’ most common recommendation is to enter into a swap arrangement to fix the rate.

The cost of the swap, especially after tax, is considered very low cost insurance relative to the risk of a rise in interest rates.

A swap is not the only way, however.  Some bankers recommended fixed rate term loans or even public bond issues if the financing is large enough. 

One of my clients raised its first high yield bond last week so I’m doing my best to help companies to reduce interest rate risk.  My banker friends would be pleased that their preaching paid off.

I can help your company to lock in low current interest rates.  Please contact me.  Thank you.

Visual Interest Rate History

On Youtube, next to my posts about interest rate risk such as “Behind the Headlines on Interest Rates” were a series of videos which visually chronicle the history of US Treasury interest rates along the maturity curve for the last 50 years with commentary by Dr. Donald R. van Deventer, founder of Kamakura Corporation. Displayed above is one of the videos entitled, “50 Years of Forward Rate Movements”.

In a great example of a picture is worth a thousand words, or in this case, 12,300 days of data, one can quickly sense (i) historical levels of benchmark US Treasury interest rates, (ii) the variations from the expected or classical term rate structure (which is more common than one would think), and (iii) the amazing volatility in benchmark US Treasury rates.

As my post “Behind the Headlines on Interest Rates” explains, there’s more to what a company pays in interest rates than just the benchmark US Treasury rates but this reveals the variability in those benchmarks themselves.

My thanks to Kamakura Corporation for creating these videos.  The company’s Youtube channel is www.youtube.com/user/kamakuracorporation and its website is www.kamakuraco.com.

Behind The Headlines On Interest Rates

 

The Federal Reserve announced that economic factors “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

This will, no doubt, influence interest rates through this period, but this is not the sole determinant of a company’s interest rate as noted in my post “Seems Smart Now“.

For example, the debt market for corporations, both large and small, is influenced by supply and demand factors in addition to the benchmark federal funds rate.  The predicted reduction in demand for corporate debt by collateralized loan obligation (CLO) funds suggests that companies may see higher new issue interest rates.  In contrast, any increase in demand by other lenders such as high yield bond and “relative value” investors may ease rates.

The recent post, “No Loan Left Behind“, by Randy Schwimmer of Churchill Middle Market Finance, now a unit of The Carlyle Group, describes these supply and demand forces at work on the larger size loan market (size above $100 million).

To support Randy’s view that high yield investors are supplying critical demand, this week one of my clients successfully priced its first high yield bond replacing other financing sources.

My message is that while Fed action gets the headlines, there are several other factors at work, behind the headlines, which influence a company’s debt rate.

Dennis McCarthy

(213) 222-8260

dennismccarthy@ariesmgmt.com

Short-term Debt Seems Smart Now

dennismccarthy@ariesmgmt.com

(213) 222-8260

With short-term interest rates at historically low levels, many small cap companies are funding all their capital needs with short-term debt.

Can you blame them?  Small cap companies are borrowing at 2 to 3% floating rates or a bit more if swapped to fixed rates.

Yes, it is a short maturity, one to three years, but the lenders will extend it when due.  They said they would.

 Yes, we all know that old maxim, fund long-term assets with long-term capital but companies are saving so much in interest by borrowing short-term.

What’s the risk, anyway? If rates start to rise, companies can refinance with long-term capital then.

I hear this a lot.  It worries me.  

Interest rates may rise unexpectedly and fast.  When the time comes to lock in long-term capital, there’ll likely be a rush to refinance.

First,  who lends for 5 to 10 years – insurance companies, specialty lenders, the public bond market?

There are limits to how much and how fast these markets can absorb new debt.

Second, what will happen to interest rates?  Spreads on corporate debt have already widened since this summer.  What do you think will happen to interest rates when there’s a rush to refinance?

I’ve been encouraging small cap companies to be prudent, to borrow some capital long-term.  Create a relationship with the long-term debt market now, before the rush.

In the rush to refinance, you’ll want your company to be the first in line because your company is already a known participant in the long-term debt market. 

Now, that’s a smart move.

Please contact me to discuss this or any of my posts. Thank you.

What now? Where can I get capital?

dennismccarthy@ariesmgmt.com

(213) 222-8260

Well, it’s the Fall of 2011, Wall Street has been highly volatile as fears of a new recession and disarray in the Eurozone dominate the news.

As I talk with clients and friends, the discussion always comes around to the question “now what?”  What if my company needs capital?  Where can I go?

First, there’s debt.

The debt markets are open for business.  Based on my experience, finance companies and banks are lending.  The public debt market is open too.

A borrower’s projections may get more “stress testing” now but interest rates are historically low.

Second, there’s asset sales

In part because debt is available, buyers are active. If your company needs to raise cash, you might consider selling a business.

I know companies who’ve raised cash in this manner.  They’ve gotten good prices for the businesses sold and are now deploying the money. 

Third, large cash-rich corporations may be a source of capital for your company. 

Sometimes these relationships take the form of direct equity investments into your company but many times they take the form of JVs, licenses, cash advances or even simple grants.

These deals work when the relationship benefits the large company’s business, even if indirectly. 

Lastly, don’t forget equity.

You may wish for higher prices when selling equity but you should also be pragmatic.  You should ask yourself “how critical is the having cash now?  What is the investment opportunity?  Does it justify the cost of raising equity now?”

Again, my name is Dennis McCarthy.  I’m happy to discuss funding options with you.  My contact information is below.