Tuesday, May 29, 2007

How Junky Is Junk?

One of the overlooked elements of this wave of mergers, acquisitions, leveraged buyouts and management buyouts we've been experiencing of late is just how frickin' cheap debt has become. I don't mean the underlying interest rates on borrowings, which are ultimately set by the federal reserve. These have not changed one bit, as I can tell from a brief consultation of those handy mortgage calculators that real estate brokers put on their websites.

Nope, I'm talking about the premiums that lenders attach to the debt of companies with different risk profiles. Want to know why Mrs. Cutesome has to miss huge chunks of her Memorial day weekend? Because many private equity firms can pay a huge premium over a public company's value, as measured by its stock price, borrow huge sums of money to pay this premium, find the debt rated at what we used to refer to as "junk", and still pay about what I'd pay for a mortgage on an apartment in the "tony Park Slope section of Brooklyn" (they don't really call it that. Yet.)

Now, via, CFO.com comes news of a study from rating agency Standard & Poor's, one of a couple of outfits that presume to tell us how risky debt is, saying that it doesn't really matter any more if your debt ends up with a "junk" rating. Well, what S&P actually says is ""With spreads compressed across all rating categories, the cost of maintaining an investment-grade rating no longer affords firms a significant cost advantage."

So you can spend hours convincing S&P you're a really good flutter, lard on much less debt than you'd ordinarily be inclined to do, and still borrow at an only slightly cheaper rate than the Leveraged To The Gills Financial Engineer. Demand for slightly riskier assets from non-bank lenders (hedge and other funds, mostly) has pushed down the price, or interest rate, of this debt.

Because ratings agencies have a certain amount of influence over the assets that many financial institutions buy, as well as, sometimes, their regulation, getting rated "investment grade" used to open the doors to an enormous universe of cautious investors. The difference in size between the cautious and less cautious investors, though, is much less stark now.

Still, what S&P has slightly neglected is the difference in premium between different types of junk-rated debt. This has become very important. Unfortunately i don't really have the time to explain the arcane numerology that the agencies use, but they have grades within the junk category, and these do confer different pricing benefits. If debt market liquidity holds up at near these levels, ratings agencies, as well as the general financial community, may just want to recalibrate the junk category downwards.


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