Is a credit bubble about to pop?


Perhaps the biggest question in the industry right now is the extent to which we are in the final days of a credit bubble, one that will inevitably pop, ushering in great portfolio pain. The debate has been raging, and you'll find plenty of rhetoric on both sides of the issue.

Breakingviews has weighed in with a bubble-meter that looks at five issues: low yields, too much debt, terms and conditions, financial engineering and investor complacency. On each issue, it assigns a score of 1 through 10, with 10 being the strongest indicator of a bubble. The average score is a 7. The highest score -- a 9 -- came in the terms and conditions category.

"In hot markets, issuers can get away with higher leverage ratios and looser lending terms. Currently, they are doing both," the author writes.

He continues, writing that, "The average debt-to-EBITDA multiples on U.S.-sponsored LBO deals has averaged 5.5 times this year and last, up from 4.2 times in 2009, according to LPC. Yet it's still below the 6.5 average in the 2007 LBO peak year. Meanwhile, issuance of so-called covenant-lite loans, which give lenders weak or no enforcement rights when borrowers' profits fall, has soared to all-time highs. And issuance of particularly lender-unfriendly Payment in Kind (PIK) loans was up around 13-fold last year from 2010, according to Morgan Stanley."

It's a sellers' market right now. In some ways, it feels like the pre-crisis days when issuers had their way. The power pendulum swung hard in the other direction for years, only to swing back in favor of issuers.

My sense is that enough people think that some sort of rotation out of debt is inevitable, and they are adjusting accordingly. We're already seeing indications of a looming migration into other asset classes, which bodes well for a graceful transition. The last think we want is a pin-pop burst that spreads pain like toxic confetti. Fortunately, a much gentler transition is more likely.

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