Cash Pouring Into Junk-Bond Funds May Signal Stock Market Chaos

By: Money_Morning

Shah Gilani writes: Investors are plowing money into junk-bond funds, which leveraged borrowers at private equity funds are using to pay dividends to themselves and to buy out more public companies.

The huge-and-growing overhang of debt-laden portfolio companies that private-equity shops want to take public - when combined with additional leveraged deals in the pipeline - will keep a lid on U.S. stock prices and could even spark a sell-off for stocks in both the United States and Europe.

Let me explain ...

Strong Currents

According to Lipper FMI Strategic Research, $1.39 billion flowed into U.S. high-yield bond funds during the week that ended June 23. The recent flow into high-yield funds - also referred to as "junk-bond" funds - was the largest since August 2003, and was the fifth-highest total on record.

The U.S. market isn't the only place where money is pouring into high-yield funds. There's also a high-volume flow of cash flowing into junk-bond funds in Western Europe, which just established a year-to-date record. So far this year, a new record $25.3 billion has poured into high-yield European bond funds - an increase of 35% from the previous record set back in 2006, says Dealogic, which tracks capital issuance trends and deal flows.

The low-interest-rate environment is prompting investors to reach for yield, inducing them to take up residence in the much-riskier neighborhood occupied by junk bonds. At the same time that investors are plowing money into high-yield/junk-bond funds, large banks are looking to place money - in the form of term-loans to big borrowers. These big borrowers give banks the scope and scale necessary to generate significant commitment, underwriting and placement fees, as well as the fat interest rate spreads typically featured by these "leveraged loans."

Good Money Chasing Bad Deals?

In a strong economic environment, a surge in junk-bond deals can be supported by the rising asset values that go hand-in-hand with an improving marketplace outlook.

As private-equity shops wheel and deal to leverage the public companies they're taking private with high-yield loans (the loan proceeds are essentially used to buy out the public shareholders), they are also streamlining their new portfolio companies to make them more productive and - hopefully - more profitable. PE firms additionally sell more junk bonds and use those loan proceeds to pay themselves (and their investors) dividends and fat "management" fees.

In a teetering economy, however, companies have very likely already squeezed out excesses and inefficiencies - even before they are bought out by private-equity players. Layoffs, scaled-back production, asset sales and de-leveraging are standard corporate fare - call it survival 101 - in a recessionary environment. But, i f demand doesn't return and isn't then substantially sustainable, no matter how much de-leveraging has already been accomplished, more will be necessary.

A Backed-Up Backlog?

However, it's in this environment that high-yield financing and large bank loans are being used by private-equity shops to pay themselves more dividends, lower the equity they have to put into new leveraged deals, and facilitate holdover financing until they can "cash out" by taking a number of their portfolio companies public again.

And that brings us to the serious problem that's brewing for private-equity shops, their investors, and the larger universe of investors in U.S. and Western European stock markets. The private-equity sector's inventory of debt-laden portfolio firms - waiting to be taken public in the desperately thin initial-public offering (IPO) markets that exist today - are backed up like traffic on the Long Island Expressway (LIE) heading out to the Hamptons on a Friday afternoon before the Fourth of July weekend.

There's no way the backlog of deals waiting to go public isn't going to act like an oppressive weight on the rest of the market. Not only are these deals un-exciting, they are leveraged companies that will require the JATO power (jet-fuel assisted take-off) of some particularly exuberant markets to lift their stocks once issued. Otherwise, the poor debut of many of these IPOs will kill-off any enthusiasm that capital markets hope to represent as investible opportunities for already-beaten-down equity investors.

In the just-concluded second quarter, 90 companies filed with the U.S. Securities and Exchange Commission (SEC) to go public. They planned to sell a combined $23.6 billion of shares, according to Bloomberg data.

The number of planned IPOs was the highest on record since the last bull market that ended in 2007.

Not ironically, over the same period, the number of IPOs that were cancelled was the highest since the collapse of Lehman Brothers Holdings Inc. (OTC: LEHMQ) in the fall of 2008. Worldwide, last quarter, 50 major IPOs were cancelled, Bloomberg reported. And with markets continuing to whipsaw - and possibly even to swoon - it's unlikely that new share issuance will pick up anytime soon.

If anything, that traffic jam on the financial markets' LIE is getting longer by the minute.

That's bad news for the private-equity shops, which invested more than $2 trillion in leveraged-buyout (LBO) deals during the easy-money, credit-crazy bubble that just exploded.

In this environment, it's important to note that leveraging up continues and that junk-bond issuance to pay dividends to private-equity masters is again on the rise.

DynCorp International Inc. (NYSE: DCP) just issued $455 million worth of high-yield bonds at 10.5% to help finance its $1.7 billion buyout by Cerberus Capital Management LP (of Chrysler Group LLC, GMAC LLC (NYSE: GOM) and other LBO-fiasco deals gone awry). Insight Communication Co. Inc. is selling $400 million of junk bonds to pay a $300 million dividend to its owner, the Carlyle Group LP. And CKE Restaurants Inc. (NYSE: CKR) is floating $600 million worth of high-yield paper to help pay for its $1 billion buyout by Apollo Global Management.

Caution is the Watchword

It was the low-interest-rate environment that drove investors to seek higher yields in mortgage securities packed with subprime loans. And low rates inflated the credit bubble in leveraged buyouts. Low rates are the catalyst here, as well.

Investors who dare dabble in stocks right now must remain aware of the overhang of leveraged IPOs coming to market. They need to be aware of the potential for another tsunami of deleveraging if eventually healthy markets can't absorb the backlog of stale deals coming and leveraged, stripped-out companies fishing in the junk market for yield-hungry fools can't make their hefty interest payments.

To avoid getting stuck on the backed-up market expressways, investors better stay alert and watch their mirrors.

But beware: That stock-market downturn that you see in your mirror ... may actually be closer than it appears.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]

Source : http://moneymorning.com/2010/07/02/junk-bond-funds/

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