Rising LBO Potential Induces Debt Sell-Off

BOND STRATEGIST: As M&A activity heats up, many investors have been scouring their portfolios to reduce exposure to companies that could be subject to debt-leveraging transactions

Dave Sekera, CFA 12 February, 2013 | 2:26PM
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The average spread in Morningstar's Corporate Bond Index widened 2 basis points last Monday in sympathy with the sell-off in the equity markets and traded in a narrow range for the rest of the week. The initial bout of fear was driven by the price declines in Italian and Spanish sovereign bonds on news of looming losses in the Italian banking system as a result of derivative trades gone awry and a widening political scandal in Spain. The credit market tried to improve Friday, but the attempted rally seemed to fizzle out early. With the blizzard bearing down on New York, many traders either took the day off or left early.

The long-rumoured leveraged buyout of Dell (DELL) was finally officially announced last week, with four banks committing nearly $14 billion in loans to complete the transaction. In addition, Liberty Global (LBTYA) announced plans to acquire Virgin Media (VMED). As part of the transaction, Liberty will increase Virgin's leverage to 4-5 times earnings before interest, taxes, depreciation, and amortization from 3.5 times currently, adding more than $3 billion in debt to the Virgin capital structure to fund the cash portion of the deal.

As merger and acquisition activity is heating up, many investors have been scouring their portfolios to reduce exposure to companies that could be subject to debt-leveraging transactions. As such, the industrials sector widened slightly more than the financial-services sector as prices fell for the bonds of potential LBO targets. Given the regulatory nature of the financials sector, we do not believe there is a reasonable chance that private equity sponsors can structure a leveraged buyout that would effectively subordinate existing bondholders.

In addition to generally improving credit metrics in the banking sector, the absence of LBO activity is one more reason we expect financials to outperform industrials in the first quarter.  This view was outlined in our first-quarter 2013 outlook. We also recently published a Premium article that highlighted issuers that we think are acquisition targets for strategic as well as financial buyers. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Dave Sekera, CFA  is a senior securities analyst with Morningstar.