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A Junk Bond Bubble?



August 16, 2012 – Comments (0)

Board: Macro Economics

Author: yodaorange

Dear METARites, I am seeing signs IMO that we are in a bubble for high yield, aka junk bonds. One recent deal pegged the bubble meter to the red for me.

First a bit of history. The largest leveraged buyout in history was Texas Utilities (TXU). TXU was a large, boring public utility serving a large part of Texas. It stated in 1927 and had built up over the years into a tens of billions dollar business. TXU had also expanded outside the US making a $7 billion acquisition of England based Energy Group in 1998.

In 2007, a consortium of Kolberg Kravis Roberts, Texas Pacific Group and Goldman Sachs took TXU private in a $45 billion buyout. It has turned out to be in the running for “worst leveraged buyout ever” which is surprising because normally those buyout firms do NOT place losing bets. They renamed the company Energy Future Holdings (EFH).

Two things primarily hurt EFH’s business:

1) The global recession reduced demand
2) EFH’s profit model planned for high $6 to $8 natural gas. Fracking has caused gas prices to do down, NOT up.

Those two factors going the wrong way have caused EFH to have a string of yearly losses. EFH lost $696 million in Q2 2012 and $1 billion year to date. [1] For the full year 2011, losses were $1,913 million, we will call it an even $ 2 billion. [2]

We can stipulate that Kolberg Kravis Roberts, Texas Pacific Group and Goldman Sachs had a bad hair day when they did the buyout. Guess who also participated? Warren Buffet purchased $2 billion of bonds during the buyout for Berkshire Hathaway. In 2010, the bonds were written down to $1 billion in value. In 2011, they were further written down to $610 million for a paper loss of 70%. WEB says that the bonds might be end up with a 100% loss. [3]

By January 2012, the market was pricing EFH bonds with a 91% chance of default with an assumption that investors would receive 14.5 cents on the dollar for each bond. [4]

Pretty grim outlook, right?

Ah yes, but PT Barnum has been proven correct yet again.

Last week, EFH issued $250 million of 6.875% notes maturing due 2017 and $500 million of 11.75% due in 2022. [5] With US treasury 10 year paper yielding ~ 1.75%, the EFH offers a sure fire, can’t miss, extra ~ 10% of yield!

Apparently, there are enough investors desperate for yield that bought out the whole $750 million offering. It also proves that at the right price, you call sell anything.

I have a great idea. Why don’t we get 11.75% bonds from about 100 different companies and put them together. We could make a great, sure fire, high return bond fund. We can choose them from different industries and localities. That would guarantee they would be uncorrelated to each other. So if one or two or five or ten go bad, the remaining ones would be money good!

If this isn’t the early stages of bubblicious high yield bond behavior, I don’t know what is. As always, bubbles have a tendency to last a lot longer than most people expect. My guess is that we are in the 2nd or 3rd inning of this game and it will take many more years before the bubble bursts.

In the meantime, Yoda will NOT be adding any EFH bonds to the widows and orphans funds.

BOTTOM LINE for conservative investors is to make SURE you know what you are buying if you invest in mutual funds or ETFs. Bottom line for higher risk investors is to break out the Dom Perignon and drink away because times are good! (You can serve Yoda a Château d'Yquem, preferably 1959, if you like.)



[1] Energy Future Holdings Q2 2012 report

[2] Energy Future Holdings Full Year 2011 report

[3] Berkshire Hathaway write downs in Energy Future Holding bonds

[4] January 2012 assessment of EFH bonds

[5] EFH issues $750 in new debt August 2012

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