Saturday, February 5, 2011

Covenant-Lite Loans are Back

One would have thought that the meltdown of the leveraged loan market in 2008 would have left a lasting impression on participants in the industry. However, the recent flood of money into the loan market has resulted in a diminution of credit standards comparable to what we saw in late 2006/early 2007. As demonstrated in the chart below, covenant-lite loans have represented 26% of all new loans issued year-to-date in 2011, nearly identical to the 25% level hit in 2007, and more than 5 times the percentage seen in 2010. While the sample size is fairly small ($8.8bn YTD 2011 vs. $100 billion in 2007), hearing the words “covenant-lite” and “PIK-Toggle” enter the lexicon of credit investors scares me tremendously.

With rates and covenants so remarkably favorable to borrowers, it is only a matter of time before the LBO machine begins to ramp up into overdrive. Supply is what broke the back of the last LBO bubble - I have little doubt that it won’t do the same this time.

Over the last year, I have been highlighting the mounting excesses in the credit markets. Admittedly, my fears have not been borne out and credit investors would have been well-served by ignoring my concerns (generally, a pretty lucrative trading strategy:). However, not in my wildest dreams could I have imagined that at this stage in the recovery, we would still be talking about zero percent interest rates “for the foreseeable future.” The Global Food Index just breached its 2008 highs and oil is flirting with $100/barrel and yet our esteemed Fed Chairman sees no evidence of inflation in the economy. How many countries have to endure mass riots over parabolic food rises before Bernanke will abandon his unyielding reliance on the heavily manipulated CPI numbers?

With rates across the entire yield curve kept artificially low, perhaps this can go on for some time. Bernanke’s comments on Thursday talking down any inflationary pressures in the economy have given investors a license to speculate. However, I have no doubt that when the Fed begins to tighten, this mini-reincarnation of the 2007 credit bubble will quickly be snuffed out.

Wednesday, February 2, 2011

Companies Stock Up Ahead of Price Increases

Here is a good article from today's WSJ ("Companies Stock Up as Commodities Prices Rise") that highlights the self-fulling prophecy of higher prices. With the price of rubber, cotton, spices, and other commodities rising to new highs over the last few months, anxious customers are accelerating their inventory purchases to try and get ahead of additional price increases. Similar to what we experienced in mid-2008, when panicky restaurant owners drained Costco shelves of bags of rice, scared businesses are accentuating the inflationary spikes by collectively buying far more than the underlying demand in their businesses would suggest is necessary.

Its difficult to say how long this could go on - and zero percent interest rates are certainly not helping - but unless end market demand truly picks up, its hard to justify this frenzied activity. In 2008, we had a good 3-4 months where it seemed like everyday the price of most commodities was moving higher. However, as Jim Grant is fond of saving, "the cure for high prices is high prices" and you can be sure that at some point high prices will break the back of this inflationary pressure.

As can be expected, the Fed's head is firmly buried in the sand and it remains highly unlikely that they will raise interest rates anytime soon. With home prices trending lower and unemployment stuck at 9.5%, Bernanke can care less that copper and rubber prices have tripled since early 2009. However, no matter how clueless the Fed, they cannot repeal the laws of supply and demand and any investor chasing this commodity spike higher ought not to forget what happened in August 2008 when reality finally took hold in the market.

This anecdote from the article perfectly captures the frenzied behavior of businesses across the country:

John Anton, Anton Sport's founder, saw the price of cotton shooting up, and decided to act. Last month, when his T-shirt suppliers warned about the fourth price rise in six months, he borrowed $300,000 through his home-equity line of credit and bought more than a year's supply. Mr. Anton typically has about 30 boxes of shirts on hand at one time, but now has more than 2,500.

"It just kind of clicked that I can borrow at 2.45%, and if cotton is going to go up between 10% and 12%, why wouldn't I do this?" Mr. Anton said. Cotton prices rose 92% last year, and are up 22% this year.

Mr. Anton, the T-shirt seller, bought mountains of shirts after receiving letters in January warning of an imminent price increase. One supplier's letter, a copy of which was reviewed by The Wall Street Journal, urged customers to "wrap up most of your pending orders and buy at the best possible prices."

"What's exciting here is we can now go to somebody like McDonald's and say: 'We have a price that's going to beat everyone around,' " Mr. Anton said. "At this point, I don't know if I'm the smartest guy in the room or the dumbest. But I can't see prices returning to where they were anytime in the near future."