Fridson: How far out does high-yield bond market look in discounting default rates?

Note: The following is a special monthly report from Marty Fridson. For his latest weekly column, please see “Industry Sharpe ratios,” published on July 30, 2013.

Relating pricing to default-rate expectations
Financial markets are generally regarded as forward-looking, as exemplified by the use of stock prices as a leading economic indicator. Such a characterization makes conceptual sense in the case of the high-yield risk premium, or spread-versus-Treasuries (SVT). Investors have the option of buying Treasury bonds, with no risk of loss from default (see note 1). Logically, they will buy high-yield bonds only if they offer enough additional yield to offset future default losses. (Default losses are defined as the speculative-grade default rate less recoveries on defaulted issues.)

In theory, the default rate expected by the market can be backed out of the SVT, as in this example based on June 30, 2013 data:

This calculation oversimplifies matters and overstates the market-expected default rate. Before agreeing to choose high-yield bonds over Treasuries, investors must be compensated not only for default risk, but also for the comparative illiquidity of high-yield bonds. This is evidenced by the excess of the average SVT for the period 1982-2012 (note 3) over the Moody’s mean annual default loss rate for the same period:

5.80% – 2.73% = 3.07%

High-yield strategists generally treat this difference as the illiquidity-premium component of the high-yield SVT. They subtract it from the option-adjusted spread (OAS), the most rigorous version of the SVT, to derive the pure default-risk premium. Users of this “breakeven” method calculate the market’s June 30, 2013 expected default rate as follows:

The practical significance of this result is that the 3.50% expected default rate exceeds the current consensus default rate forecast. Moody’s, for example, currently projects a U.S. default rate of only 2.40% over the next 12 months. Strategists deduce that high-yield bonds are undervalued because according to their pricing, the market expects a default rate about one percentage point higher than econometric default-rate models predict.

Why the preceding calculation is fallacious
Let us hasten to say that we strongly disagree with the just-described methodology on several grounds. To begin with, strategists always apply a 40% recovery rate when in fact the rate varies widely from year to year, as an inverse function of the default rate. More problematic is the fact that liquidity conditions vary widely from period to period, making it erroneous to apply a standard premium of 3.07% or thereabouts. By the logic of the breakeven method, there have been periods in which the high-yield market expected a negative default rate. For example:

This is not a unique result. According the breakeven model, there were 25 months between 1997 and 2012 in which the market expected a negative default rate. Given that a negative default rate is impossible, the most widely used method for backing out the expected default rate and valuing the high-yield market fails the test of internal consistency.

As discussed elsewhere, we believe the soundest method for deducing the market’s expected default rate utilizes the distress ratio, defined as the percentage of issues in the high-yield index characterized by an option-adjusted spread (OAS) of 1,000 bps or more, indicating a high probability of default (note 4). Furthermore, the best-supported method of determining the value of the high-yield market does not attempt to back out the market’s expected default rate and compare it to a default-rate forecast. Our own methodology instead employs a multiple regression model to explain the historical variance in OAS. This approach enables us to calculate, for a given month, a fair-value spread, given the level of total risk. (Total risk is not limited to default risk and does not incorporate a fixed – and therefore, at most times, inaccurate – illiquidity premium). Comparing our methodology’s fair-value spread to the actual spread determines whether high-yield bonds are rich, cheap, or fairly valued (note 5).

Why the market’s range of vision matters
Notwithstanding the inherent superiority of a method that does not indicate that the market frequently predicts a negative default rate, most strategists cling to the flawed breakeven model. Their fidelity to a discredited approach raises a problem that is of at least academic interest. Specifically, by comparing the market-implied default rate to a one-year default-rate forecast, the breakeven method implicitly assumes that the OAS reflects only defaults that are expected to occur within the next 12 months. Such an assumption is certainly open to question.

Consider this case:

At the beginning of Year 1 the consensus default rate forecast is 2% in Year 1 and 6% in Year 2. The high-yield index’s OAS is 547 bps. According to the breakeven method, the pure default risk premium is:

At first blush, the high-yield market appears greatly undervalued, as its OAS indicates an expected default rate of 4%, double the consensus of 2% in Year 1. Is it not possible, though, that the market is being a bit more farsighted and taking into account that the default rate is predicted to triple to 6% in Year 2?

What if the market is splitting the difference between the 2% Year 1 default rate and the 6% Year 2 default rate and discounting a 4% rate? In that case, the OAS of 547 bps is exactly in line with the default rate outlook. Rather than being grossly undervalued, high-yield bonds are fairly priced, according to this analysis. For steadfast proponents of the breakeven method, it matters a great deal whether the market sees beyond one year or ignores evidence that the default rate may be considerably higher or lower in the subsequent year. Indeed, it is conceivable that the market looks out to the third or fourth year or beyond.

The question we propose to answer: “How far out does the high-yield market look in discounting future default rates?”

To answer the question, we make an essential assumption that on average, the market accurately estimates future default rates for as far out as it can. Based on that assumption, we reason that the period (number of years) over which the market looks ahead at default rates is the period over which the cumulative default rate best explains (has the highest correlation with) the beginning-of-period OAS.

We proceed by regressing the Master II’s year-end OAS from 1996 to 2011 against the default rate in each corresponding, subsequent year. Then, we regress OAS against the cumulative default rate for the corresponding two subsequent years, for the corresponding three subsequent years, and so on up to 10 years. The default rate used in this analysis is the Moody’s speculative-grade, percentage-of-issuers series. (These are global statistics but U.S. issuers dominate the speculative-grade universe.)

In the chart below, the vertical scale (y-axis) indicates the percentage of OAS variance explained (R-squared) by the subsequent default rate. The horizontal scale (x-axis) shows the number of years over which the subsequent, cumulative default rate is measured. For each year we show both the R-squared for all years in our observation period and the R-squared excluding results related to year-end 2008 (the inordinately large OAS on that date, 1,812 bps, may produce an exaggeratedly high correlation).

If the R-squared for the two-year cumulative default rate were higher than the R-squared for the one-year default rate, it would imply that the market was looking out beyond one year and discounting default rates out to two years. We find, however, that the percentage of variance explained is substantially higher over a one-year horizon than over a two-year horizon (55.07% versus 31.89%, using the figures that exclude the 2008-related results, as detailed above). The R-squared trails off sharply in Years 3 and 4. We conclude that users of the breakeven method need not worry about their method, flawed as it is, being made worse as a consequence of the market discounting future defaults beyond one year.

Supplemental analysis
Our thinking about the main question of this report led us to run one additional test. We broke down the speculative-grade universe into its alphanumeric (Ba1, Ba2, etc.) components. Next, we calculated the monthly mean OAS for each alphanumeric category for the period 1988-2012. (Moody’s first applied its 1, 2, and 3 modifiers for the Caa category in 1998.) For each horizon from 1-10 years, we ran regressions to determine how much of the variance in OAS among the Master II’s equivalent alphanumeric categories (BB1, BB2, etc.) was explained by those categories’ cumulative default rates.

In the chart below, the y-axis indicates the percentage of variance in OAS among the alphanumeric rating categories that is explained by cumulative default rates. The x-axis shows every horizon from 1-10 years.

R-squared is very high (94.17% or above) in every horizon. There is a slight escalation from 99.16% in Year 1 to 99.98% in Year 2, followed by a monotonic decline through Year 10. These results suggest that the market looks out two years in differentiating the risk premiums on different gradations of speculative-grade debt. That is despite the fact that the previous chart indicates rather forcefully that the market does not look beyond one year in determining the risk premium on the high-yield category as a whole.

As for applications of this ancillary finding, portfolio managers can use it to assist judgments that at a point in time the differentiation in OAS among the rating categories is too great or too small. Suppose, for example, that with the year-ahead forecast of the default rate at 3%, the market seems to be rewarding investors too generously for shifting from B issues to Caa issues. Further suppose that the portfolio manager believes the default rate will escalate to 5% in months 12-24. Our finding would lend support to the view that the market is looking out beyond the first 12 months and that therefore the pickup from B to Caa is fair, rather than generous.

Concluding thoughts
One useful finding of this study is the very high explanatory power of future default rates with respect to the high-yield OAS, as illustrated in the first chart. To be sure, that explanatory power is with the power of hindsight. If we had a crystal ball to tell us the default rate for the next 12 months, we would incorporate it into our fair-value model. As it is, we must rely on explanatory variables that are known at the time of the valuation. The contemporary (trailing) default rate is known, but at least as far as OAS goes, has little explanatory power. By far the most powerful variable in our fair-value model is a measure of credit availability derived from the Federal Reserve’s quarterly survey of senior loan officers.

Martin Fridson, CFA
CEO, FridsonVision LLC

Research assistance by Xiaoyi Xu


1. Treating U.S. Treasury obligations as default-risk-free instruments was an analytical convention, rather than a literal reflection of reality, even before Standard & Poor’s downgraded the debt from AAA on Aug. 5, 2011. The AAA rating does not indicate total absence of default risk over an extended period, even though no corporate issuer has defaulted within one year of holding that rating.

2. This figure does not represent the yield on Treasuries of one particular maturity. The option-adjusted spread on the high-yield index is derived by spreading each of the index’s constituent issues against its corresponding point on the Treasury yield curve. We calculate the underlying Treasury yield by subtracting the index’s option-adjusted spread from its yield-to-worst. The resulting figure tends to correspond roughly to the five-year Treasury yield.

3. We calculate this historical figure as the yield-to-maturity difference between the BofA Merrill Lynch High Yield 100 Index and the five-year Treasury Index. The superior definition, referred to in note 2, the mean OAS on the High Yield Master II Index, is available only from Dec. 31, 1996 onward. From that date through the end of 2012, the rough-and-ready calculation based on the High Yield 100 exceeds the OAS calculation by 34 bps.

4. See “How to tell when distressed bonds are attractive” (Nov. 28, 2012).

5. See “Determining fair value for the high-yield market” (Nov. 13, 2012).


Patriot Coal seeks exclusivity, DIP amendment to avoid default; UMW talks continue

Patriot Coal filed a motion last night seeking a 90-day extension of its exclusive right to file a plan as it continues negotiations with the United Mine Workers of America over changes to its collective-bargaining agreements, and discussions with potential lenders regarding exit financing and a rights offering.

Patriot is also seeking bankruptcy-court approval of an amendment to its $802 million debtor-in-possession financing to lower the minimum-EBITDA thresholds under the DIP by more than half in order to avoid a default.

Patriot has until Sept. 2 to file a reorganization plan, and until Nov. 1 to solicit votes on a plan under its current exclusivity periods. If granted, its third and latest request would extend filing exclusivity through Dec. 1, and solicitation through Jan. 30, 2014.

The company’s Chapter 11 cases passed the one-year mark on July 9, and now stand at their “most critical juncture,” Patriot said. Although the company won bankruptcy-court approval to unilaterally alter its collective-bargaining agreements with its employees represented by the UMWA, the company said it remains in negotiations with the union over the terms of those modifications and on the funding of a trust for certain benefits of union retirees.

Patriot also said it is in active discussions with Knighthead Capital Management and Aurelius Capital Management on the potential terms of a reorganization plan that would involve an investment of hundreds of millions of dollars into the debtors’ estates through a rights offering backstopped by Knighthead and Aurelius. U.S. Bankruptcy Judge Kathy Surratt-States recently approved payment of up to $2 million to the two hedge funds to cover fees and expenses related to the rights offering. As of last month, Aurelius and Knighthead held $77.9 million and $57.4 million, respectively, of the company’s 8.25% senior notes due 2018, representing 31.16% and 22.94%, respectively, of the total outstanding, according to court filings. Aurelius also holds about $19.7 million, or 9.83%, of the company’s 3.25% convertible senior notes due 2018.

Patriot said it is also in discussions with “other parties” regarding exit financing proposals and potentially providing the debtors the capital they need to emerge as a viable and competitive company.

In addition to its exclusivity motion, Patriot asked the court to approve a DIP amendment that would lower its minimum-consolidated-EBITDA financial covenant thresholds from $110 million by July 31, to $70.6 million, and ultimately from $205 million by Dec. 31 to just $101.3 million.

“In the past year the debtors have had to contend with continuous and sharp declines in the demand for, and price of, metallurgical coal, and the negative effects that such downward trends have had on the debtors’ internal financial forecasts,” Patriot said. “Accordingly, because these downward trends in the coal markets have continued unabated, the debtors currently believe there is substantial likelihood that, if the amendment is not approved, they may not comply with the current EBITDA thresholds beginning in the third quarter of 2013.” Citibank and Bank of America, administrative agents for the first-out and second-out portions of the DIP, respectively, would be entitled to amendment fees, which will be kept confidential. Citibank launched the amendment on July 29, and Patriot said it hopes the requisite first-out lenders consent by Aug. 6.

A hearing on the exclusivity request and DIP amendment is scheduled for Aug. 20, in St. Louis. – John Bringardner


Pinnacle Entertainment $850M notes price at par to yield 6.375%; terms

Pinnacle Entertainment today completed an offering of senior notes via joint bookrunners J.P. Morgan, Goldman Sachs, Bank of America, Deutsche Bank, Wells Fargo, Credit Agricole, Barclays, and UBS, according to sources. Terms for the B+/B2 offering were inked at the midpoint of talk with a $50 million upsizing, and an early read from the gray market points to roughly a one-quarter-point gain on the break, the sources add. The deal backs Pinnacle’s acquisition ofAmeristar Casinos in a deal valued at $2.8 billion, including $1.9 billion in debt. Proceeds from the bonds, along with those from a concurrent loan offering, will finance the cash consideration for the acquisition, refinance existing credit facilities, pay related transaction fees and expenses, and redeem the $446 million outstanding of Pinnacle 8.625% senior notes due 2017, which will become callable at 104.313% of par as of Aug. 1. Proceeds will also provide working capital and funds for general corporate purposes after the acquisition. Financing also includes a $2.6 billion senior secured credit facility that includes a $1.6 billion, covenant-lite institutional loan and a $1 billion, five-year revolving credit.

Pinnacle will keep in place two subordinated notes issues; $350 million of 8.75% notes due 2020 and $325 million of 7.75% subordinated notes due 2022. Pinnacle will assume Ameristar’s existing $1.04 billion issue of 7.5% notes due 2021. Without taking asset sales into account, pro forma leverage would be 2.9x through the secured debt and 6.6x total. Net leverage would be 6.3x. Terms:

Issuer Pinnacle Entertainment
Ratings B+/B2/BB-
Amount $850 million
Issue senior notes (144A)
Coupon 6.375%
Price 100
Yield 6.375%
Spread T+411
FRN eq. L+389
Maturity Aug. 1, 2021
Call nc3; @ par +75% of coupon
Trade July 30, 2013
Settle Aug. 5, 2013 (T+4)
Joint Bookrunners JPM/GS/BAML/DB/WF/CA/Barc/UBS
Px talk 6.25-6.5%
Notes upsized by $50 million

Bankruptcy: ResCap judge denies noteholder request to disqualify company lawyers

U.S. Bankruptcy Judge Martin Glenn rejected a request from the junior secured noteholders in Residential Capital’s Chapter 11 proceedings that he disqualify lawyers for the company or the creditors’ committee from participating in intercreditor disputes, criticizing the JSNs for trying to “derail” the case, according to Bloomberg News.

The junior noteholders argued that intercompany claims could affect more than a billion dollars in creditor recoveries, but that in representing multiple debtor entities, ResCap’s lawyers had a conflict of interest.

Glenn said in court this morning that the JSNs were trying to force the court to make a determination about the value of intercompany claims, according to Bloomberg.

The disqualification motion was a “destructive remedy for a non-existent problem,” the creditors’ committee said in court filings ahead of the hearing, characterizing the move as a tactical attempt to extract post-petition interest. “The relief sought would render the prosecution of the plan impossible, cause milestones to be missed, and likely disrupt the unprecedented settlement with [Ally Financial] and the consenting claimants that made possible a largely consensual plan with substantially increased payments to all creditors, including full recovery for the JSNs.”

ResCap’s lawyers filed a proposed reorganization plan earlier this month incorporating a $2.1 billion settlement with Ally Financial and outlining a path toward emergence from Chapter 11 by Dec. 15. ResCap’s global settlement with Ally, which Glenn approved on June 26, tops Ally’s initial pre-petition settlement offer by $1.35 billion. The agreement settles all existing and potential claims between ResCap and Ally, and potential claims held by third parties in relation to ResCap.

“The JSN’s dissatisfaction with their treatment is ironic given that just over a year ago, an ad hoc group of the noteholders and their legal and financial professionals signed off on a plan support agreement based on a much smaller $750 million settlement with AFI that did not assure them of full recovery of the principal amount of their claims,” the creditors’ committee noted. – John Bringardner


Detroit Ch. 9 judge proposes case deadlines, seeking plan by March 1

The judge overseeing Detroit’s Chapter 9 proceedings this morning filed a proposed schedule for the case, suggesting a March 1, 2014, deadline for the city to file its plan of adjustment.

Lawyers for Detroit and other interested parties in the case will be able to comment on Judge Steven Rhodes’ proposed dates at an Aug. 2 bankruptcy court hearing.

The March deadline potentially gives Detroit Emergency Manager Kevyn Orr, who filed the city’s Chapter 9 petition on July 18, several months to see the plan through to confirmation before his 18-month term ends in September. Michigan Governor Rick Snyder appointed Orr as emergency manager this March to oversee the city’s financial operations, temporarily giving him greater executive authority even than Detroit Mayor Dave Bing.

U.S. Bankruptcy Judge Steven Rhodes also filed a proposed mediation order last week recommending Chief District Judge Gerald Rosen, of the U.S. District Court for the Eastern District of Michigan, be appointed as mediator. Although Chapter 9 is distinct from Chapter 11, mediators are often appointed in large and complex corporate restructurings to help keep a case moving swiftly through the court. Both creditors and the debtor in the Chapter 11 proceedings of Residential Capital have recently praised Judge James Peck of the Southern District of New York for his efforts as a mediator in resolving contentious issues outside of the courtroom.

Meanwhile, Michigan Attorney General Bill Schuette filed his appearance before Judge Rhodes Monday morning after issuing a statement this weekend that he would defend public pensions at risk under the city’s Chapter 9. “Retirees may face a potential financial crisis not of their own making, possibly a result of pension fund mismanagement,” Schuette said on Saturday. “Michigan’s constitution, Article 9, section 24, is crystal clear in stating that pension obligations may not be ‘diminished or impaired. As Attorney General, I will defend the rights of Michigan citizens and defend the Constitution of the State of Michigan.” – John Bringardner


HG bonds: IBM prints $2.15B sale in two parts to back GCP; terms

International Business Machines (IBM), a frequent issuer and low-cost borrower, today completed a two-part $2.15 billion offering at levels in line with price talk. The deal included a $650 million floating-rate tranche due July 2015 placed at L+3, and $1.5 billion of 3.375% fixed-rate notes due August 2023 at T+83, or 3.413%. Both tranches were printed at the tight end of guidance in the L+5 and T+85 areas, respectively, and in line with initial whispers.

When IBM last tapped a 10-year maturity, in July 2012, it established a record-low interest rate for that tenor with $1 billion of 1.875% notes due August 2022 at T+65, or 2.05%. For reference, the issue is trading today on average at 3.18%, and at G-spreads from T+75-77, according to MarketAxess.

On May 2, or the date generally associated with a decisive inflection higher in interest rates, the storied market timer sold a $2.25 billion offering across 0.45% 2016 notes at T+25, or 0.55%, and 1.625% 2020 notes at T+67, or 1.74%. The 2016 reoffer yield remains the second-lowest rate on record for a corporate issuer at that maturity, behind the 0.51% reoffer inked just a few days earlier by Apple with 0.45% three-year notes priced at T+20.

Armonk, N.Y.-based IBM completed its first bond deal of the year in February, when it placed $2 billion evenly across a floating-rate tranche due 2015 at LIBOR minus two basis points, and 1.25% fixed-rate notes due 2018 at T+47, or 1.35%.

Proceeds from today’s offering will be used for general corporate purposes. Terms:

Issuer International Business Machines (IBM)
Ratings AA-/Aa3/A+
Amount $650 million
Issue SEC-registered senior notes
Coupon L+3
Price 100.000
Maturity July 29, 2015
Trade July 29, 2013
Settle August 1, 2013
Px Talk L+3; guidance L+5 area (+/-2 bps); IPT L+5 area
Issuer International Business Machines (IBM)
Ratings AA-/Aa3/A+
Amount $1.5 billion
Issue SEC-registered senior notes
Coupon 3.375%
Price 99.680
Yield 3.413%
Spread T+83
Maturity August 1, 2023
Call Make-whole T+12.5
Trade July 29, 2013
Settle August 1, 2013
Px Talk T+83; guidance T+85 area (+/-2 bps); IPT mid-to-high T+80s area
Notes Proceeds will be used for general corporate purposes

PIK toggle high yield bond issuance soars as market heats up

PIK togggle bond issuance - monthly

There’s more evidence of a rebounding U.S. high yield bond market: PIK toggle deal volume has soared in July as issuers take advantage of an institutional investor market that once again has become accommodating in its search for yield.

PIK toggle deals – which give the issuer the option of repaying the debt “in kind” (as opposed to cash) – have totaled roughly $2.85 billion so far in July, making it the busiest month for these deals since October 2012, and the second-busiest since the pre-Lehman days of September 2008.

In fact, some of the July transactions have been the largest PIK toggle offerings since the leveraged finance boom of 2008, according to LCD’s Jon Hemingway. Michaels Stores, for instance, last week priced an $800 million offering, part of which will fund a dividend to private equity sponsors Bain Capital and Blackstone Group. Investor demand for the deal was such that it was increased from $700 million. The issue was rated CCC+/Caa1.

Also last week, healthcare networks concern MultiPlan completed a $750 million PIK toggle deal, part of which backs a dividend to sponsors BC Partners and Silver Lake. The Multiplan issue also is rated CCC+/Caa1. And just today U.S. retailer Party City unveiled a $300 million PIK toggle offering backing a dividend to private equity sponsor Thomas H. Lee.

The appeal of these deals to investors is obvious. The Michaels deal priced with a coupon of 7.5% (cash) or 8.25% (PIK), while MultiPlan priced with a coupon of 8.375% (cash) or 9.125% (PIK). Those figures are in contrast to the 6.79% average yield of U.S. senior unsecured high yield deals, as of July 25, according to S&P Capital IQ/LCD (that average yield is calculated on a rolling 30-day basis). Again, it’s worth noting that many of the PIK toggle deals being completed have relatively low ratings, which contributes to the relatively hefty yield.

PIK togggle bond issuance - annual

PIK toggle bonds came about during the rising-rate leveraged finance environment of 2004 and 2005. Their use peaked during the heady capital markets days of 2007 and 2008, before the financial market collapsed (you can read more about how PIK toggle bonds work here). So far in 2013 PIK Toggle issuance totals roughly $6 billion, compared to only $1.4 billion during the same period in 2012. PIK toggle issuance picked up during the second half of last year, to finish 2012 with $6.7 billion in volume. That’s the most since the $13.4 billion recorded during 2008. – Tim Cross


Patriot Coal may pay Aurelius/Knighthead fees for possible IPO

Patriot Coal may pay hedge funds Aurelius Capital Management and Knighthead Capital up to $2 million to cover fees and expenses related to a potential rights offering to fund the company’s emergence from Chapter 11, according to a July 26 order signed by U.S. Bankruptcy Judge Kathy Surratt-States.

As of last month, Aurelius and Knighthead held $77.9 million and $57.4 million, respectively, of the company’s 8.25% senior notes due 2018, representing 31.16% and 22.94%, respectively, of the total outstanding, according to court filings. Aurelius also holds about $19.7 million, or 9.83%, of the company’s 3.25% convertible senior notes due 2018.

In a June 18 motion filed with the bankruptcy court in St. Louis, Mo., Patriot said it was seeking approval to pay the legal fees of the law firm jointly representing the two funds in connection with the possible backstopped rights offering, Kirkland & Ellis, as well as the fees, up to an aggregate of $75,000, of legal and accounting advisors retained by each fund in connection with certain tax issues related to a backstopped offering.

The company did not provide any timing for completing a backstop agreement or reorganization plan.

Patriot said last month it was not yet committed to an Aurelius/Knighthead backed proposal, noting at one point in its motion that has “begun negotiating with certain of their key constituents regarding the terms of a plan of reorganization, and have engaged in discussions with potential sources [other than Aurelius and Knighthead] of emergence financing,” and at another point in the motion that it “remain[s] fully open to financing proposals from all credible sources.”

At the same time, however, the company also said that the Aurelius/Knighthead deal “would serve as the linchpin of a plan of reorganization and the successful conclusion of these Chapter 11 cases,” and would provide a “promising opportunity to consummate a plan of reorganization and successfully emerge from Chapter 11 in the near-term in a manner that maximizes value for the debtors’ estates and stakeholders.” – John Bringardner/Alan Zimmerman


Party City unveils $300M of PIK-toggle notes for dividend; 4th PIK-toggle offering this month

Party City is the latest issuer to launch a PIK-toggle notes offering to fund a dividend. Pricing is expected today following a conference call with investors at 11:00 a.m. EDT. Bookrunners on the $300 million deal are Bank of America, Deutsche Bank, Barclays, Goldman Sachs, Morgan Stanley, and Moelis, according to sources.

The six-year senior notes will become callable after 1.5 years with a first call price at 102% of par, declining to 101% and then par. These are contingent cash-pay notes and will have a standard 75 bps step-up in coupon when paying in-kind, according to sources. The notes include an unusual equity-clawback window from 6-18 months after issuance for either up to 40% of the issue or the whole issue at 102% of par.

Issuance comes at PC Nextco and ratings are not yet assigned. For reference, Party City is rated B/B2, with stable outlooks. The existing senior unsecured notes are CCC+/Caa1.

Thomas H. Lee Partners in 2012 completed a $2.69 billion purchase of a majority stake in the retailer. The financing for the LBO also included a $1.125 billion term loan, 8.875% senior notes due 2020 (CCC+/Caa1), and a $400 million, five-year asset-based revolver.

This marks the fourth PIK-toggle offering launched to market this month following deals for Michaels Stores ($800 million), MultiPlan ($750 million), and Schaeffler Holding ($1 billion), the three largest such deals since 2008. Thus far in 2013 there have been 14 regular-way PIK-toggle notes offerings completed for a combined total of $5.35 billion. That is nearly the issuance total for the full-year 2012 of $6.25 billion, which was the most since 2008. Roughly $4.95 billion of last year’s total, or 79%, was used to fund dividends, the most ever. – Jon Hemingway


European high yield funds see €210M inflow of investor cash; €1.3B YTD

J.P. Morgan’s weekly analysis of European high-yield funds shows a €210 million inflow for the week ended July 24. Of that total, €16 million is attributable to ETFs. The reading for the week ended July 17 was not revised from a €189 million inflow. The provisional reading for June is a €2.4 billion outflow. That compares with a €723 million inflow in May, a €555 million inflow in April, a €579 million inflow in March, a €156 million outflow in February, and a €1.8 billion inflow in January. The latest estimate for total inflows this year through June is €1.3 billion.

The size of weekly inflows is growing, with the latest reading the largest inflow since mid-May. Nonetheless, the €475 million to have flowed into funds over the last three weeks pales into insignificance compared with the €2.4 billion that flowed out in June. However, the recent inflows have led bond managers to actively seek to put money to work, and as a result issuers have flocked to market ahead of the summer lull. According to LCD, July has so far recorded a new-issue volume of €7.43 billion, making it the second-largest monthly volume this year, behind May’s €8.95 billion total (which was the largest monthly volume ever recorded). Furthermore, the July total should increase as Cabot Financial aims to drive-by today with a £100 million ticket, while S&B Minerals should price a €275 million deal before month-end.

In the U.S., retail cash inflows to high-yield funds increased to $3.3 billion in the week ended July 24, according to Lipper, a Thomson Reuters company. This is the fourth consecutive inflow, following a $2.7 billion infusion last week, and two smaller inflows totalling $461 million in the weeks prior. This is the largest single one-week inflow of the year, and the largest since a record inflow of $4.2 billion was tracked in the week ended Oct. 26, 2011. ETF inflows represented 37% of the total this past week, or roughly $1.2 billion.

Retail-cash inflows into bank loan mutual funds and ETFs were $1.85 billion for the week ended July 24, according to Lipper FMI, a division of Thomson Reuters. That reading marks a new record for the weekly reporter sample, topping a previous high of $1.71 billion from last week, which itself bested a total of $1.55 billion for the week ended March 20.

As reported, J.P. Morgan only calculates flows for funds that publish daily or weekly updates of their net asset value and total fund assets. As a result, J.P. Morgan’s weekly analysis looks at around 50 funds, with total assets under management of €10 billion. Its monthly analysis takes in a larger universe of 90 funds, with €27 billion of assets under management. For a full analysis, please see “Europe receives HY fund flow calculation.” – Luke Millar