AT&T and What Comes After the Stumbling, Tottering, Reach for Yield

My favorite credit news source, CreditFlux, reports so of the latest crazy in bondland. To wit: AT&T. In the third-largest deal in history, they managed to place a $17.5 billion offering with the sole aim of financing a gigantic purchase of DirecTV. Most of bonds have a call option at 101 should the purchased not go through by 201511. $3.5 billion of these bonds have a 30 year maturity at 4.75%.

Here’s the 10Y CDS spread for AT&T. The issue resulted in a 10bps rise in premium.

AT&T.jpg

Below is DirectTV 10Y spreads. The labels indicate M&A triggers.

DirectTV.jpg

So get this. AT&T tried to integrate their phone, cell, web, and cable services starting before 2000. They gave up trying. So now they want to buy assets to have a crack at integrating satellite service. Investors apparently think that AT&T will deliver a meaningful product with real market value and not screw it up this time. Yes, AT&T apparently can stitch a Frankenstein together into a supermodel.

Or, alternatively, investors don’t really care as long as they get 4.75% coupons. In clumps they came, loose, sloppy gaggles and assorted frayed knots of mutual funds, hedge funds, pension funds, insurance cos—all stumbling, lurching, and plodding for yield.

It’s as baffling as it is understandable. Concepts like moderation and boundaries are totally foreign in a zero interest rate world. And in a zero interest rate world, it is not much of a journey to get to a zero yield world. Finding returns means an extended stay in crazy town.

Moving beyond the dubious specifics of AT&T, what does this mean?

Near-zero yields push term, liquidity, volatility, country, and credit premia significantly lower in the fixed income world. Since German Bunds are yielding negative rates in the sub 10-year sectors and the ECB’s QE program is in full blast, investors will eventually become intolerant of negative yields. Curves flatten dramatically to levels that appear to make little sense against domestic valuations or fundamentals. Yield spreads across countries tighten. Big FX carry trades will dominate as countries with even marginally steeper curves get bought by investors in countries with marginally flatter curves. Liquidity premia will vanish despite the reality that liquidity can disappear any moment. The search for yield will grow more, not less, intense.

What happens next is default. Time and again we see that excessive borrowing dramatically shifts firm viability in the wrong direction. There are three types of borrowers:

  • borrower that can pay interest and principal at all times

  • speculative borrowers that can pay interest out of cash-flow but need refinancing of principal to avoid default when loans come due

  • borrowers only able to pay interest and principal if they can refinance on the basis of rising asset prices on book

The latter type of borrower is really nothing more than a Ponzi scheme. When a firm cannot pay both interest and principal, EBITDA doesn’t really matter much and it is not meaningful to characterize speculative and “Ponzi” borrowers in terms of EBITDA. What matters is whether the combined net present value of future cash-flows and book value of the firm exceeds its debt. It explains why these kinds of borrowers need rising book asset prices to remain solvent. Asset prices go south and you get defaults.

It explains why policy setters emphasize a nice bid underwriting asset prices— but they can’t control where all the liquidity goes. And they can’t keep people from binging on debt. Both these roads lead to crazy-town. And when earnings can’t service debt due to rising rates, deteriorating business conditions, or whatever, the Ponzi collapses.

Banks won’t releverage when their loan book is cratered with write-offs. They use cash to provision and recapitalize instead. So defaults ultimately bifurcate credit markets into those that qualify for credit but don’t want/need it, and firms that want/need it, but can’t qualify for it.

Returning to AT&T. Deflation hurts borrowers and thus it hurts highly leveraged companies that have spent $15 billion plus raising funds for acquisitions. So money rotates out of corporate debt and rotates into sovereigns. Over time, the need for yield dominates and investors move back into high grade, less leveraged corporates rewarding prudence.

It becomes an age of balance sheet strength, not revenue growth. In Japan, companies were deleveraging and repaying debt for almost 15 years. This is not yet happening in Europe or the US, but an extended period of lower growth would likely lower corporate bond supply as corporates lean-up and reduce debt.

We are probably not that far from this. But in getting there, we will have quite a time navigating around the smoking mounds of blow-torched capital.


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