Junk Bonds Under Pressure

The drop in supply of equities and rise of bond issues, are not unrelated--Searching for Alpha, the monthly index newsletter for July 2007

For the last few years, the supply of equities traded in the U.S. has fallen, and the number of bond issues has risen. These aren't two unrelated trends, but a natural byproduct of the buyout boom.

There are many temptations for corporate executives to transition from a publicly traded entity to a privately held one. Sarbanes Oxley has proven both expensive and onerous for public companies. Increased scrutiny of executive compensation has made it more difficult for CEOs to make a real lot of money. In most cases, the corporate jet and other perks have been made strictly off-limits.

As a result, buyout firms have had their pick of the litter in buying publicly traded firms. They finance these deals with easy, cheap credit. And as the appetite for these loans have increased, several forms of aggressive, "covenant-lite" packages have been developed. One example is the toggle note, a security in which the issuer has the option of remitting interest payments in the form of cash or more debt.

The recent and well-publicized problems in the subprime mortgage market have put a halt to many of these forms of LBO financing. After years of taking whatever the market offered, investors are finally starting to turn down loan packages with higher leverage, forcing buyout firms to make such deals more attractive.

So far, this has only affected larger buyout deals with above-normal inherent leverage. If financing problems were to spread, stocks might pull back, as the supply-demand dynamic would result in more equities to purchase and fewer buyers. At present, this outcome doesn't appear very likely, but in the interim, high yield bonds will probably continue to experience weakness. This asset class may be better left unexplored until credit spreads widen enough to increase yields and push the reward-risk dynamic in favor of the investor.

The Monthly Index Report for July 2007

Index

Jun-07

QTD

YTD

Description
S&P 500 Index* -1.78%

5.80%

6.00%

Large-cap stocks
DJIA*

-1.61%

8.53%

7.59%

Large-cap stocks
Nasdaq Comp.*

-0.05%

7.50%

7.78%

Large-cap tech stocks
Russell 1000 Growth

-1.49%

6.86%

8.13%

Large-cap growth stocks
Russell 1000 Value

-2.34%

4.93%

6.23%

Large-cap value stocks
Russell 2000 Growth

-0.57%

6.69%

9.33%

Small-cap growth stocks
Russell 2000 Value

-2.33%

2.31%

3.80%

Small-cap value stocks
EAFE

0.15%

6.67%

11.09%

Europe, Australasia & Far East Index
Lehman Aggregate -0.30%

-0.52%

0.98%

U.S. Government Bonds
Lehman High Yield

-1.80%

0.22%

2.87%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

2.29%

9.31% 7.13% Managed Futures
3-mo. Treasury Bill*** 0.39% 1.28%

2.64%

All returns are estimates as of June 30, 2007. *Return numbers do not include dividends.

** Returns are estimates as of June 28, 2007.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.

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