You Only Give Me Your Funny Paper

Debt markets turn grouchy as creditors ask for more.

Before the brain was established as the body’s ruling organ, the stomach was thought to be king. Descartes may have thought and therefore known that he was, but he reckoned that most of his moods were regulated by his guts. Credit markets seem never to have adjusted to this reordering, and still think with their stomachs. This week they were grumbling, and several big bond sales were postponed until they settle. “It’s not a buyers’ strike,” says Paul Read, a bond fund-manager at Invesco, “but a bit of indigestion.”

Until two Bear Stearns hedge funds got into trouble last week, things had been bubbling along merrily in the credit markets. Last year default rates on high-yield bonds fell to their lowest since 1981, according to Edward Altman of New York University. They have stayed low this year and, with healthy corporate profits and plenty of liquidity, there is no reason to suggest that is about to change.

Even so, there are signs that investors still holding American subprime mortgage debt might not be the only ones feeling a little queasy. In Asia a sizeable bond sale from MISC, the world’s largest owner of liquefied natural gas tankers, has been postponed. In Europe Arcelor-Mittal, the world’s largest steelmaker, put back a bond sale too. US Foodservice, an American wholesaler, has made such hesitance look like a trend by delaying plans to raise $2 billion in loans. That spells trouble for even bigger issues on the horizon, like the $62 billion that Cerberus Capital Management, an investment firm, hopes to raise for Chrysler, which it is buying.

Although modest repricing is going on, investors are still willing to take risks if they are paid a little more to do so, and plenty of deals are still going ahead. Yet all is not well. “There’s so much leverage in the system that it wouldn’t surprise me to see more problems,” says Jim Reid, credit strategist at Deutsche Bank. The place to look for a decisive shift in sentiment is in the buy-out market, which has been fuelled by a trio of habits that in more sober times would have had lenders reaching for the Alka-Seltzer.

The first of these lies in the burgeoning market for “covenant-lite” loans. Loans normally require borrowers to maintain financial thresholds, like limiting debt to five times cashflow. But a huge number are now lacking such “maintenance covenants”, which means that banks have less grip on borrowers when business turns sour. The total amount of covenant-lite loans issued in the first two quarters of 2007 has been $105 billion, which tops the $32 billion of all such loans written from 1997 to 2006, according to Standard & Poor’s, a rating agency.

The largest issuers of the covenant-lite loans are private-equity firms, which have been able to dictate terms to lenders. Kohlberg Kravis Roberts (KKR), a big buy-out firm, filed to raise a record $16 billion of such loans last month to finance its buy-out of First Data. Covenant-lite loans now account for almost 35% of all loan issuance in America. Many such loans are issued as senior-secured debt by stronger borrowers, making many of them safer than sub-prime residential mortgages.

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