Grant's Interest Rate Observer

Child's Play

An increasingly stark contrast in credit:  capital flows forth like beer at a frat party, while large swaths of corporate debtors nevertheless struggle to ward off the economic grim reaper.  

Proximate location of the gushing monetary spigots is the Old Continent.  Data from the ECB via The Wall Street Journal show that European buying of non-European bonds reached €160.8 billion ($191.7 billion) in the May-July period, the most on record.  It’s easy to understand their wandering eye:  yields on the BofA ML Europe High Yield Index have recently dropped below those of the BofA ML U.S. Treasury Index.  

 

Domestic borrowers are the beneficiary, and they are well aware of their strategic upper hand. That fact is underscored by a dispatch in Bloomberg yesterday noting the increasing irrelevance of historically standard lender safeguard clauses. 

 

Protections have gotten so lax in the $1 trillion market for U.S. leveraged loans that if an offering comes with decent covenants, lenders take it as a sign that something’s wrong with the deal.  ‘You have to think twice when you see a loan with a covenant these days’ says Thomas Majewski, managing partner and founder of Eagle Point Capital Management. 

 

‘It’s basically the worst it’s ever been in terms of loan covenant protections,’ says Derek Gluckman, senior covenant officer at credit-rating firm Moody’s Investors Service.

 

Beyond demonstrating the leveraged loan market’s resemblance to a Giffen good (where demand rises as a product becomes more expensive), the piece goes on to detail creditors’ ready willingness to accept transparent accounting gimmicks. Note the example of private equity firm Hellman & Friedman’s $265 million loan offering to fund its buyout of audio-visual company SnapAV:

 

The new owner used an accounting method known as add-backs to reduce a measure of the company’s leverage, which makes it look more creditworthy. The add-backs, which take into account things like deferred revenues, boosted Ebitda by about a third to $50.1 million from $37.5 million. That reduced its leverage to 5.4 times from more than 7 times, according to loan documents sent to investors. 

 

Still, SnapAV attracted enough willing lenders to sell the loans slightly cheaper than was initially discussed – with no financial maintenance covenants.

 

Ready access to capital is not enough for large swaths of the retail realm.  A June research report from Moody’s noted that the number of retailers sporting distressed ratings of Caa (“judged to be of poor standing and are subject to very high credit risk”) or lower rose to 22 from 19 in February, higher than at any point in the great financial crisis and representing about 15% of the agency’s retail and apparel universe.

 

That number could grow further: Moody’s notes that seven additional B2/B3 rated issuers (“considered speculative and subject to high credit risk”) face an aggregate $1.1 billion in maturities on asset-backed loan and revolving credit facilities in 2018.

 

The contrasting duality of lending market euphoria and recession-levels of corporate duress is perhaps best illustrated by a bulletin yesterday from LCD News, titled: “Mattel Snags Looser Credit Covenants in the Wake of Toys ‘R’ Us Ch. 11.”

 

Mattel today disclosed amendments to its credit facility…providing for relief from its consolidated debt-to-consolidated EBITDA requirement for the fiscal third quarter of 2017, and an increase in the ratio threshold to 4.5x for the fiscal fourth quarter, from 3.75x previously.

 

In its most recent 10-K filing, Mattel noted that Toys ‘R’ Us was its second biggest customer after Wal-Mart, contributing about $600 million in revenues for 2016, about 11% of its top line. Mattel shares have been more than cut in half from their mid-2016 interim highs,  and net debt of $2.37 billion as of June 30 compares to $690 million in trailing 12-month adjusted EBITDA, a leverage ratio of about 3.4 times.  2016 revenues of $5.45 billion represented the fourth straight year of contraction, down 16% from 2013’s $6.5 billion. 2016 free cash flow of $332 million is down more than 25% from the $446 million generated in 2013.

 

In choosing to adjust its borrowing terms, Mattel management provides a glimpse of its future: More leverage, weaker revenue, lower free cash flow. Creditors don’t seem to mind.