Treasurers Embrace Pay-in-Kind Bonds as Ghost of Lehman Fading

Companies are selling debt with terms last seen before credit markets froze, showing why the world’s biggest bond fund manager says another bubble may be brewing.

JohnsonDiversey Holdings Inc., a Sturtevant, Wisconsin, maker of cleaning supplies, and Wind Acquisition Holdings Finance SpA, parent of Italy’s third-largest mobile-phone company, sold bonds that can pay interest in new debt instead of cash, the first such deals since 2007, according to Bloomberg data. Goodman Global Inc. raised $320 million to pay its owner, leveraged buyout firm Hellman & Friedman, a dividend, one of at least seven similar offerings since November.

Two years after credit markets seized up, treasurers are luring investors to junk bonds that returned a record 58 percent last year, as measured by Bank of America Merrill Lynch indexes. U.S. sales of $162 billion beat the all-time high of $149 billion in 2006, Bloomberg data show. The rally means “choices are limited and the value is diminishing,” according to Bill Gross, who runs the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co.

“Six months ago I wouldn’t have imagined being able to do this deal,” said Karim-Michel Nasr, head of corporate development in Paris at Weather Investments SpA, Wind’s holding company. “It is an issuer’s market, but in the sense that investors are looking for companies that are pushing maturities out, storing up cash for a rainy day.”

Capital Access

At least two dozen borrowers since November have asked lenders to change terms of debt agreements to permit bond sales, extend loan maturities or pay dividends to their owners, Bloomberg data show. Access to capital means defaults will likely drop to 3.9 percent by November from 12.7 percent a year earlier, New York-based Moody’s Investors Service says.

Speculation that companies will have less difficulty making payments has led investors to accept lower interest rates and looser borrowing terms. The extra yield demanded on junk bonds instead of Treasuries narrowed to 6.39 percentage points at the end of 2009 from almost 19 percentage points on March 9, Merrill Lynch indexes show. Speculative grade debt is rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.

“Investors are beginning to let their guard down and consider some riskier structures in the credit markets,” Scott Minerd, who helps supervise more than $100 billion as Guggenheim Partners LLC’s chief investment officer, said in an e-mail.

‘More Cautious’

Gross said Nov. 13 that he’s growing more concerned about corporate bonds because the economic recovery isn’t assured. The firm is “more cautious,” Paul McCulley, a money manager and member of the firm’s investment committee, said Jan. 4 in his 2010 outlook posted on Pimco’s Web site.

The U.S. unemployment rate was at or above 10 percent in October and November, compared with an average of 4.6 percent in 2006 and 2007.

Fund managers have little choice but to buy high-yield debt with looser restrictions as investors pour into the market, said Edward Altman, creator of the Z-Score that calculates bankruptcy probabilities.

“Very lenient terms” show “there’s definitely been a shift back to the issuer,” said Altman, a finance professor at New York University’s Stern School of Business. “I don’t see the fundamentals justifying it.”

Investors added a record $153.2 billion to U.S. bond funds in 2009, according to Cambridge, Massachusetts-based research firm EPFR Global. Of that, $21.3 billion went to funds focusing on junk-rated debt, compared with outflows of $1.9 billion in 2008.

‘We Forget’

Bondholders lost 26 percent on junk debt in 2008, according to Merrill Lynch indexes. The collapse of Lehman Brothers Holdings Inc. caused yield spreads to widen from a record low 2.41 percentage points the previous year as investors fled all but government debt.

“I’m looking at some of the things that are being priced and I’m saying, ‘Wow, how quickly we forget,’” said JohnsonDiversey Chief Financial Officer Joseph Smorada. The market is “starting to get a little dangerously aggressive,” he said.

The company sold $250 million of so-called toggle debt due in May 2020 on Nov. 20 that allows it to pay a 10.5 percent interest rate either in cash or notes for the first five years. The first pay-in-kind bonds since 2007 were part of a $2.6 billion recapitalization in which New York-based LBO firm Clayton Dubilier & Rice Inc. agreed to buy a 46 percent equity interest in the company.

Moody’s gave the notes its fifth-lowest ranking of Caa1, saying the debt is five times more than adjusted earnings before interest, taxes and amortization costs. It has had negative free cash flow the past three years, though it’s expected to break even in 2010, Moody’s said.

‘Dangerously Aggressive’

“In early 2009, I don’t think we could have borrowed a nickel if our life depended on it,” Smorada said. Investors submitted bids for almost four times the amount of notes offered, he said.

Investors haven’t lost discipline and companies are mainly selling bonds to refinance or cut interest expenses, said William Cunningham, the head of credit strategy and fixed-income research at State Street Corp.’s investment unit in Boston.

Companies in the S&P 500 Index held 8.2 percent of their assets, or about $2 trillion, in cash and short-term investments during the third quarter, up from $1.6 trillion, or 6.4 percent, a year earlier, Bloomberg data show.

‘A Difficult Time’

“It’s something we need to watch,” Cunningham said. “But is it the early signs of froth and excess? Not when you look at the numbers. I’m pretty confident that were an aggressive deal to come, or any sort of deal that has much looser credit standards or covenants, if it were to come by a company that had deteriorating fundamentals, investors would give that credit a difficult time.”

Wind Acquisition of Luxembourg raised $1.1 billion last month selling 7.5-year, 12.25 percent notes in dollars and euros that allow it to pay interest with more debt until 2014. Wind, controlled by Egyptian billionaire Naguib Sawiris and the parent of Wind Telecomunicazioni SpA, boosted the offering 50 percent as demand rose.

S&P cut Wind’s credit rating one level to B+ from BB- as the company used the sale to pay a dividend to its parent. The Dec. 9 downgrade reflects “a more aggressive financial policy” as the company sustains “weaker” units, S&P analyst Leandro De Torres Zabala in Madrid said in a statement.

Undercutting Efforts

The investment flood has undercut efforts to toughen restrictions that protect investors, said Alexander Dill, senior covenant officer at Moody’s in New York. Many covenants are “largely replicating” rules from 2006 and 2007, Dill said in a Dec. 10 report.

TRW Automotive Inc., the world’s biggest supplier of vehicle-safety equipment, sold $250 million of eight-year notes in November rated Caa1 with covenants “substantially unchanged” from its 2007 indenture for debt graded four steps higher at Ba3, according to the Moody’s report. The Livonia, Michigan-based company said Dec. 22 it raised $400 million in term loans as lenders amended and extended its revolving credit facility.

The restructuring, made possible by improved earnings and investors discounting an “Armageddon” scenario, provided cash until at least 2014 and reduced secured debt, said Chief Financial Officer Joseph Cantie. Companies looking at the “wall of maturities” in 2012 are “saying it’s going to be difficult, better to take care of that stuff early on,” he said.

Quintiles Dividend

Two weeks after JohnsonDiversey’s deal, Quintiles Transnational Corp., the world’s biggest tester of medicines for drugmakers, sold $525 million of 9.5 percent toggle notes due in 2014 to yield 10.06 percent, or 7.77 percentage points more than Treasuries. The deal was increased from $400 million.

Quintiles said it will use some of the proceeds to pay a dividend to its owners, which include a group led by founder and Chief Executive Officer Dennis Gillings, Fort Worth, Texas-based TPG and Bain Capital LLC in Boston. The notes have rallied since the sale, driving the yield down to 9.42 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

David Coman, a spokesman for Durham, North Carolina-based Quintiles, declined to comment.

Goodman Global, the second-largest U.S. maker of residential and light-commercial heating, ventilation and air conditioning systems, sold five-year senior discount notes last month that yield about 12.5 percent to pay a dividend. Lenders that financed Houston-based Goodman Global’s $2.6 billion leveraged buyout approved the payment of as much as $115 million.

Reduced Debt

As of Sept. 30, Goodman had reduced debt to about 4 times earnings before interest, taxes, depreciation and amortization costs from 5.6 times in the first quarter, Moody’s said in a Dec. 10 report. Pen Pendleton, a spokesman for San Francisco- based Hellman & Friedman, declined to comment.

“The companies that have done well are being rewarded by being given a little more latitude in how they operate,” said Jason Rosiak, a fund manager overseeing $3 billion at Pacific Asset Management, an affiliate of Pacific Life Insurance Co. in Newport Beach, California. “But that just leads to inferior companies down the line having the same type of access.”


--With assistance from John Glover in London and Pierre Paulden in New York. Editors: Robert Burgess, Alan Goldstein