What would it take to spark a serious sell-off? The answer to this hypothetical question is almost always the same: if a big private equity deal came to grief, that might be the catalyst.
Private equity deals, funded by the generous terms on offer for high-yield (”junk”) bonds, have become so important for stocks, the argument goes, that such an event would jolt markets out of complacency, and maybe even into panic.
That scenario may not remain hypothetical much longer. Markets shuddered on Wednesday after news that a $650m high-yield bond offering from US Foodservice, needed to fund its buy-out by the private equity giant Kohlberg Kravis Roberts, had been postponed. Underwriters had not found enough buyers, and had decided to wait.
Coming on the heels of the problems for Bear Stearns’ hedge funds, which had invested in sub-prime mortgages, this was enough to spark a frisson of risk aversion. Investors piled into short-dated Treasury bonds, and got out of riskier plays such as borrowing in yen.
The effect was clearest in Europe, where the credit default swap market sharply increased the cost of insuring against default in high-risk credits.
Whether or not the fears are confirmed, a credit correction looks overdue. Research by Morgan Stanley shows that the weighted average cost of capital, which combines the cost of equity and debt financing, is actually lower for “B”-rated (”junk”) companies in Europe than for investment grade peers.
How could this happen? The yields payable on junk bonds fell below 7 per cent earlier this year, sharply narrowing the gap with low risk credits. Meanwhile the earnings yield on the Dow Jones Stoxx large-cap index of European stocks is about 8 per cent, compared to about 5.5 per cent for small caps.
Thus, small, risky companies can access capital more cheaply than safer large companies. This state of affairs in turn implies it would be wise to prepare for more falls in the credit market.
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