Heinz, U.S. Airways, Dell: How a junk bond bubble is driving a buyout and merger boom

February 15, 2013

The merger and buyout boom of 2013 is upon us! Some of America’s biggest companies are coupling up faster than frisky teenagers at their first unchaperoned party.

On Thursday alone, Warren Buffett’s Berkshire Hathaway and private equity firm 3G Capital announced a $23 billion purchase of H.J. Heinz Co., the iconic producer of ketchup and other fine foods, and American Airlines and US Airways announced a merger. Earlier in the month, Michael Dell and private equity firm Silver Lake has announced a plan to buy PC maker Dell back from its public shareholders for $24 billion, and Comcast bid $17 billion to buy the remainder of NBC Universal from General Electric it didn’t already own.

Ketchup is easily the finest of the tepid sauces. (Toby Talbot/AP)
Ketchup is easily the finest of the tepid sauces. (Toby Talbot/AP)

After a long fallow period in which companies were too focused on dealing with their own internal challenges to consider major acquisitions—and credit was too scarce to finance them—the floodgates seem to be opening. Some of these deals make sound strategic sense (American and US Airways are such a logical merger pairing that the deal should have happened years ago). Others are a little harder to parse (if investor Michael Dell has ideas for how the computer company could be run better, you’d think he could just go down the hallway and tell CEO Michael Dell about them).

But what many of the deals have in common is that they are being unleashed by a surge in corporate credit. The markets for bonds in even risky companies are becoming unfrozen to a degree they haven’t been in half a decade, and there seems to be some pent-up eagerness to do big deals. It's a lot easier to make a buyout or merger work when bankers and bond investors are so eager to lend you the money to make them happen.

In effect, the spate of deals is a logical byproduct of what investors in the bond market are doing: Throwing debt at corporate America, even those without good credit ratings, on highly favorable rates. This is most apparent in the market for junk bonds, debt issued by companies that are considered risky bets by the credit rating firms.

Investors are so eager to buy that debt that “high yield” isn’t all that high. On Thursday, junk bonds were yielding only 6.09 percent, based on a Bank of America-Merrill Lynch index. Compared to the roughly 2 percent that 10-year U.S. Treasury bonds are paying, that means that investors are getting only about 4 percentage points of extra compensation for lending their money to risky companies rather than the U.S. government. That’s not as low as this “risk premium” was during the bubble-licious days right before the crisis—but as this chart shows, remains below its typical levels for the last 15 years or so.


The line shows the spread between the Bank of America-Merrill Lynch high yield index and the 10 year Treasury bond yield. It is a proxy for the risk premium for junk bonds.

That’s prompted some hand-wringing about the possibility that the runup in junk bonds is a bubble; as the Federal Reserve has pushed down interest rates across the economy, investors, desperate for something that yields more than the paltry 2 percent paid by Treasuries, will take on a lot more risk for little extra compensation.

I’ve previously argued that neither the stock market nor Treasury bond market are in a bubble, and stand by those. But in the market for junk bonds—and the buyout binge that they are enabling—there is a much stronger case.

You would expect for junk bonds to yield more stocks; think of it this way: While both give the investor the risk of losing money, with the stock market, the investor also gets the upside of future earnings growth if a company succeeds. And the management works for the shareholders (and tend to be willing to treat bondholders badly if circumstances warrant, for example by taking on more debt and thus making the old debt riskier).

That’s why, before the recession in late 2007, the earnings yield of the Standard & Poor’s 500 was about 5.8 percent, while junk bonds were yielding 9 percent. That gap is the extra compensation that junk bond investors were getting for having less upside and less control.

But now that’s reversed! The stock market’s earnings yield is 6.6 percent, which is actually higher than the 6.1 percent that junk bonds are yielding. Buyers of junk bonds are tolerating lots of risk and not even being compensated. That suggests a market that is somehow out of whack. And there’s a quite plausible case that the Federal Reserve’s quantitative easing policies are part of the story. With the Fed buying billions of Treasury bonds and mortgage backed securities, those who would normally buy those assets have to buy something else. But it’s easy to imagine that this doesn’t affect all assets equally. Investors normally inclined to buy bonds may not be willing to move that money into stocks, but will buy junk bonds, even if the prices seem unfavorable.

The question is, if junk bonds are indeed overpriced, what would a correction look like? And would that cause any real problems for the economy as a whole, or merely some losses for investors in those products? Those are questions that, as a speech from Fed governor Jeremy Stein last week makes clear, policymakers are starting to think hard about.

But in the meantime, as the merger boom continues, keep an eye on the junk bond market to know whether it can keep the party going.

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Ezra Klein · February 15, 2013