Bonds' Carefree Days Get a Bit Cloudy

Bonds had a big year, but the easy credit could end in '07.
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The bond market's vault doors were flung wide open to U.S. corporations in 2006, but look for Wall Street banks to be a little more stingy in 2007.

U.S. companies sold more than $813 billion in bonds in 2006, the biggest year ever for corporate borrowing, says Thomson Financial. The market for junk bonds was particularly hot, with the dollar value of high-yield bonds sold to investors rising 53% from the prior year to $127 billion.

A perfect climate of low interest rates, relaxed lending standards and a tidal wave of leveraged buyouts all came together to make 2006 a whale of a year for

Bank of America

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,

Citigroup

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,

JPMorgan Chase

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,

Merrill Lynch

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,

Morgan Stanley

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and Wall Street's other fee-hungry bond underwriters.

In 2006, Wall Street bankers were all too eager to please their corporate customers and feed the borrowing frenzy, which also went to pay for stock buybacks and special dividends. Banks and brokers raked in $4.97 billion in bond underwriting fees, a 46% gain over 2005 -- a revenue bonanza that helped fuel a record year of earnings on Wall Street, reports Dealogic, a market data service.

And on top of all those bonds, commercial lenders arranged $500 billion in so-called leveraged loans, high-yielding bank debt that buyout firms also use to finance deals.

But the borrowing spree and days of easy money on Wall Street may come to an end in 2007, as banks begin to worry about the impact of a slowing economy on the ability of companies to make their debt payments. The market for bonds backed by mortgages to consumers with shaky credit histories is showing signs of cracking, as borrower defaults are on the rise.

Bond market bears are pointing to signs of trouble in the so-called subprime mortgage market as a harbinger of things to come for the broader debt market. But for now the doomsayers are in the clear minority, as overall bond defaults are running near all-time lows and the debt market ends 2006 on a high note.

November, for instance, was a banner month for junk bonds, corporate notes that carry the greatest risk of a default, says Dealogic. Total junk bonds issued in the month topped $25.4 billion, trouncing the old one-month record set in May 2003, when companies sold $16.4 billion in high-yield bonds.

In 2006, private equity firms used junk bonds, in combination with leveraged bank loans, to pull off

several eye-popping LBOs. Buyout firms sold $5.95 billion in high-yield bonds to finance a $17.6 billion takeover of Freescale Semiconductor. Another $5.7 billion in junk bonds were used to pay for the $21 billion buyout of hospital operator HCA.

The expectation is that cash-rich private equity firms will continue their buying binge in 2007. But with buyout firms relying on bonds and bank loans to finance up to two-thirds of an acquisition, the LBO market could be in for a shock if banks tighten their wallets and start raising borrowing costs.

"There is so much money that needs to be put to work in the marketplace, these very risky companies that would potentially go into bankruptcy in a more normalized market have very easy access to capital and financing," says Robert Kania, a senior credit analyst at State Street Global Advisors. "If that financing goes away, it will lead to more rapid defaults and the credit cycle beginning to turn."

Peter Nerby, a senior vice president at Moody's Investors Service, who covers large financial institution, says a turn in the credit cycle to a less hospitable environment for borrowers is inevitable.

"It happens every three or four years, and we're due," he says.

Nerby is looking for "triggers" -- some unexpected geopolitical event, or the collapse of a big company -- that would cause a sudden widening in the spread between the yield paid on government and corporate bonds. Bond spreads typically widen when corporate bonds are perceived as more risky to invest in than Treasuries. Nerby says a significant widening of bond spreads would send a chill through the debt market.

Some say that chill may be just around the corner, given the recent turmoil in the subprime mortgage market, or loans to homeowners with poor credit histories.

In recent weeks, at least two subprime mortgage lenders -- OwnIt Mortgage Solutions and Sebring Capital -- shuttered their doors, as the slowdown in the housing market hits borrowers on the edge the hardest. Meanwhile,

H&R Block

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says it's considering selling its Option One subprime mortgage business, which recently reported a sharp rise in poor-performing subprime home loans.

Indeed, delinquencies for all mortgages are on the rise, according to the Mortgage Bankers Association. But the percentage of subprime loan payments that are past due is up the most. The trade group says that in the third quarter, some 12.5% of the nation's subprime loans were listed as "past due," a little under a one-percentage-point rise from the second quarter.

The trouble the nation's least creditworthy consumers are having is spilling over to the bond market, where loans are packaged together and sold to investors as asset-backed notes. Fitch Ratings says it downgraded a record number of subprime mortgage-backed securities in the third quarter and is likely to do the same in the fourth quarter.

The credit agency has a negative outlook on the subprime market for 2007. In the past year, Wall Street churned out about $500 million in subprime mortgage-backed bonds.

Now it's a long way from the subprime market to the world of corporate debt. But bond watchers worry that what's ailing the bottom rung of the lending world could spread up the ladder, especially if inflation rises and makes it more costly for corporations to borrow.

In other words, the bond market's best days may be behind it.