The dangers of leveraged buyouts

published 13 July 2006

Bryn Jones, investment manager of the Rathbone Ethical Bond fund tells MoneyWeek where he'd put his money now.

Credit spreads in the UK corporate bond market have recently started to widen after more than two years of contracting to tight levels. Since 2001, most corporate bonds have outperformed gilt bonds, but this has led investors to ask if the credit market has turned. Has it?

It is certainly the case that if credit spreads widen across the board, we might see corporate-bond prices fall relative to gilt prices in general, but this isn't going to happen across the board: the yield on high-quality company bonds still remains attractive to many investors. That said, investors should be aware that the market could suffer from some credit-specific problems in 2005.

Several risks to corporate bonds have been well flagged: macro-economic risks such as a weaker economy are always prevalent; headlines suggesting poor business confidence have done little to halt the weakening credit story; and poor retail-sales figures in February and March have contributed to dwindling confidence in credit markets. But outside of these risks lurks a less well-documented danger - leveraged buyouts (LBOs).

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Beware leveraged buyouts: the risk to corporate bonds

An increase in the number of cash-rich businesses and of private-equity firms looking for deals means that a growing number of companies are potentially at risk of being bought out - there have been rumours of several in the UK market recently.

For equity investors, an LBO can be good news as they tend to be paid a premium for their shares. However, it is often a different story for debt investors. After an LBO like this, a firm will be much more highly leveraged (thanks to the debt taken out to buy it), and that means the bonds may be downgraded to non-investment grade, or even "junk" status. This immediately pushes yields on the bonds up and prices down. The downgrades might also force investors not permitted to hold non-investment grade debt to sell their holdings, triggering another detrimental effect on the bond price.

Beware leveraged buyouts: the best sectors for bondholders

Sectors that are structurally prone to buyouts, owing to their cyclical nature, include retail and media. The retail sector is particularly unattractive, because of the weak outlook for the consumer. Banks, however, are not so much at risk: they are already highly leveraged and would be unable to operate with lower credit ratings, as the higher cost of borrowing would place significant pressure on margins. Furthermore, regulation renders LBOs difficult in this sector owing to capitalisation requirements. For this reason, and because of their strong cash flow and cash generation, we hold bonds in Bank of Scotland, Northern Rock and Royal Bank of Scotland. The same holds for the insurance sector, so we like this too.

We are also keen on telecoms, a sector that was aggressively downgraded between 2000 and 2002, as rating agencies factored in the huge expenses they incurred on licensing agreements and other costs. However, telecoms are now actively de-leveraging their balance sheets, are cash-generative and looking to improve their credit ratings. This means the bonds are likely to outperform other corporate bonds in the medium term. We hold France Telecom and Deutsche Telekom, because they have been active inde-leveraging balance sheets.

Currently, our portfolio has a relatively short duration at 6.2 years (duration quantifies the sensitivity of a bonds price to interest-rate changes; the higher the duration, the lower the sensitivity). This is on the view that interest rates could rise by June on the back of underlying inflationary pressures.