In February, when Ben Bernanke gave his report to Congress, he spoke of his concern about “Excessive risk taking”. On May 10 he repeated his warning:
very low interest rates, if maintained for a considerable time, could impair financial stability. For example, portfolio managers dissatisfied with low returns may “reach for yield” by taking on more credit risk, duration risk, or leverage.
So what is Ben talking about? What does it mean when he says “reach for yield”? I think I may have found a good example of what Ben is referring to. Consider this bank financing that was completed last week:
Borrower: KIK Custom Products
1st lien = $420Mn – Priced at LIBOR plus 425bp – priced at 99.
2nd lien = $220Mn – Priced at LIBOR plus 825bp – priced at 98.
Floor pricing = Minimum LIBOR was set at 1.25% (100bp over current LIBOR rate)
Company rating = Caa/B-
Fees = Undisclosed – must have been big – 3+%
Book runner = UBS
KIK Custom Products makes bleach and soap. The company is owned by CI Capital Partners, a NYC based LBO outfit. There is no publicly available financial information for KIK, but the pricing/rating and the sponsor tell me that this is a highly leveraged deal. What kills me is that this is a recap deal. This financing replaces the existing debt of KIK, and therefore it is on substantially better terms than what existed before the recap.
This is a junk deal. It’s not suitable for widow and orphans – but that’s where this paper is going to end up. This loan will work its way into the many Loan Mutual Funds that are available to retail investors. Small investors have been pouring money into bank loan funds. Every month for the past four-years money has flown into this investment class. So far this year $20Bn has found its way to junk bank loan funds. Another $900Mn came in last week.
As an ex junk guy, I have no problems with the KIK deal – provided that this dodgy paper ends up in the hands of true ‘Sophisticated Investors’. But I do have a problem with the fact that this deal could not have happened were it not for Ben Bernanke and his unending squeeze on returns for small investors.
The second lien tranche of the KIK deal has a return north of 10%. The only exit strategy for this paper is another re-cap; cash flow from operations at KIK will not pay this loan down. So this is a one-way-out deal. I think deals like this must have Bernanke looking over his shoulder. He must know that this is the perfect description of investors “reaching for yield”.
Some will look at the KIK deal and conclude that this is evidence of a healthy capital market. I see it it quite the opposite. This type of financing is an accident waiting to happen. The fact is that Bernanke’s money policies have long since crossed over from being something that contributes to economic health and stability, to something that is adding to systemic risks and instability. I suspect that Bernanke is well aware of this fact, so are other members at the FRB. If you’re looking for evidence that Bernanke has pushed the string too far, the KIK deal is all you need to look at.
If Bernanke is honest with the facts, he would wind down QE as fast as he could. If he doesn’t, then his warnings over the past few months about the risks of cheap money are just a lie. So Ben has a hard choice in front of him. Either he backs off of his reckless money policy, or his legacy goes up in smoke. The bubbles are popping up all over in 2013, I don’t think that Ben wants to go down in the history books as another Fed Chairman that creates bubbles that come crashing down.
I think there is a high probability that the Fed lowers the amount of QE purchases in June. That’s just a few days away. The gold and bond markets have been “saying” that QE is ending for the past few months. The equity and junk markets have largely ignored the signs. June is setting up as an interesting month.