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It's Official, the Credit Markets Are Going Berserk Again

The latest sign that the debt markets are awash in liquidity comes in the form a $500 million covenant-light debt issuance to pay a dividend to its private-equity owners.

Aleris International Inc—a Beechwood, Ohio aluminum company that emerged out of bankruptcy last year and is now owned by Oaktree Capital Management, Apollo Management, and Sankaty Advisors—sold the seven year notes at par yesterday to yield 7.625 percent.

The bonds offer some of the weakest lender protections of any deal to come to market recently, according to analysts at Moody’s and Covenant Review quoted in Michael Aneiro’s story in today’s Wall Street Journal. In particular, the covenants don’t provide checks on the ability of the company to borrow more and push cash out to sponsors.

For those who aren’t familiar with this kind of deal, let me give some background. It’s a dividend deal, which means that Aleris is borrowing money and then immediately paying it out to its owners—the three private equity sponsors. The company has the debt, but the sponsors get the money. In some sense, the deal resembles a cash out home equity loan—you lever up to get some free cash to buy other stuff you want.

In a normally functioning credit market, bond investors tend to want these deals to have tight restrictions on further debt-to-dividend deals. In the industry, these are known as “restricted payments.” Typically, the sponsors will only get one bite at the restricted payment apple—after that the bond investors expect to get paid back or at least see debt-to-equity ratios reduced before the equity sponsors can suck out more cash.

Aleris was able to get carve outs that allow it to move assets into entities that aren’t subject to restrictive covenants. Those entities will then be allowed to borrow against those assets—and send the dividend back up to the sponsors. It also has a restricted-payment covenant that is 4.7 times as great as the 2010 market median—amounting to 24.8% of total company assets, compared with a 2010 media on 5.4 percent.

One sign that this isn’t a one-off deal: the Aleris bonds actually priced below the expected yield. Aneiro writes that “price guidance for the Aleris offering had anticipated yields in the area of 7.75 percent, slightly higher than the 7.625 percent yield at which the notes sold. The notes, which are noncallable for three years, are rated B3 by Moody's and B- by Standard & Poor's, slightly below the midpoint of the speculative-grade spectrum.”

What’s behind the appetite for the Aleris bonds? The Federal Reserve's January survey of senior loan officers showed that lenders were easing lending to larger firms. The loan officers cited a better economic outlook and competition from bank and non-bank lenders as the source of the new willingness to lend. In short, banks and bond buyers are racing each other to the bottom once again.

It’s somewhat terrifying that we’re already bulldozing the barriers to risky lending that were supposedly erected in the wake of the financial crisis. But it shouldn’t be that surprising. Treasury yields are still very low—despite a recent inflation-wary uptick to 3.6 percent on the 10-year note—and investment grade corporates are paying rock-bottom prices.

As a result, the market is awash in liquidity seeking yield. There’s only so low yield can go on the riskier end without becoming redundant—so instead of paying with better pricing, investors pay with looser covenants.

The issuance of covenant-light deals is taking off. In 2010, just 5.1% of first-lien institutional loans qualified as covenant-light. This year, 26 percent of the deals have been covenant-light, according to S&P.

The situation is likely to get even worse. Every deal structured this way puts pressure on investment banks to arrange ever more aggressive deals on behalf of their private equity clients. Apollo got 7.65 percent with a swiss-cheese restricted payment covenant? KKR is going to want that plus PIK payments for the next deal. Each new loan or bond deal will push the bounds of “innovation” out a bit further.

At the root of all this is the warping of the market created by the Fed’s ever-lasting easing policy. It destroys the yield on safe bonds, pushing yield seekers into riskier deals. And it provides cheap liquidity to banks, providing more cash to the great liquidity hunt. Increasing fears of sovereign debt in Europe and municipal debt in the US also contribute to this push into risk.

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