Five bond market risks to worry about: Pimco

Leslie Shaffer | Writer for
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Bond investors hungry for yield have pushed further and further into high-risk territory and Pimco sees five warning signals that credit markets are getting overly frothy.

"The lower reaches of the credit market have become particularly stretched," Christian Stracke, global head of Pimco's credit research group, said in a note last week. "High yield has become not-so-high yield, with credit spreads almost back to 2007 levels in many cases."

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The first major risk he sees in the credit market is a throwback to the pre-global financial crisis days: the 100 percent loan-to-value (LTV) high-yield deal.

"Everyone thinks that zero-down loans died when the subprime and Alt-A spigot was shut off in 2008. Not true," he said. "In the last six months, we have seen several new LBO (leveraged buyout) deals with total debt essentially equaling the true enterprise value of the firm, and many more in the 80–90 percent range."

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While the issuers may claim the deals aren't anywhere close to 100 percent LTV, they are using pro forma earnings before interest, taxes depreciation and amortization (EBITDA), he noted.

"The steps in drafting 'pro forma EBITDA' can be the close cousin of those in the subprime 'liar loans' from a not-too-distant past," he said.

The second risk Stracke sees in the credit market is a surge in "covenant lite" issuance, where the covenants or restrictions on borrower behavior, such as limits on the amount of debt a borrower can take on, have been stripped out.

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Yet another risk comes from a "dividends before coupons" trend, he said, citing the Alternative Tier 1 (AT1) capital instrument for European banks under new Basel III rules.

"In theory, banks are now required to sell bonds with coupons that could be turned off while shareholders still receive dividends," Stracke said. "That would be an extreme scenario, but one that warrants a highly discriminating approach to this emerging sector."

The fourth emerging risk is that secondary liquidity in the bond market is still historically tight, he said.

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"Investors can buy aggressive deals at new issue, and they may be able to flip them for a day or two, but thereafter the secondary liquidity in the deal vanishes," he said. "The smaller deals that will inevitably be near-zero-liquidity issues generally come with a concession to more liquid deals, but that concession has dwindled to perhaps 25 basis points (bps) or even less in the high-yield market, and maybe 5 bps in the investment grade market."

The final emerging risk is a focus on "net debt," rather than gross debt or gross liabilities, Stracke said.

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"The consensus is that many companies are flush with cash, and therefore that cash can be netted against outstanding debt," he said. "But the devil is in the details."

He noted cash is often trapped in offshore tax havens, where repatriation is only possible after a hefty tax bill. In addition, analysts often use all of the cash on the balance sheet to calculate net debt, without considering how much may be needed for working capital to keep the business operating, he said.

Another concern is which debt figures are used as in bankruptcy, bondholders aren't the only people lining up to divide a company's recovery value, he noted, citing liabilities including pension funds, litigation reserves and deferred taxes.

Others also see rising risks in the credit market.

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"Continuous injection of liquidity, hunt for yield and relatively better valuations have led to strong performance by corporate credit (investment grade and high yield) over the last five years. As a result, valuations appear increasingly stretched," Societe Generale said in a note last week.

It believes corporate credit is vulnerable if newsflow deteriorates.

"The acceleration of the re-leveraging of corporate balance sheets through buybacks and M&A might just be that trigger," it said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1