A V Rajwade: When the music stops

WORLD MONEY

The change in sentiment has affected even investment-grade bonds - new issues fell to a three-year low.

It was somewhat ironic that almost on the very day that the IMF increased its world growth forecast for the current year, most major equity markets slumped. And, the better than expected GDP growth in Q2 in the US has failed to enthuse the markets. Students of financial markets would be reminded of an old adage: expect a trend movement when markets react to news in a direction opposite to what is normally expected. Is this happening to world equities?

Much of the comment about the fall on Wall Street has referred to the de-fusing of the credit market euphoria, as the proximate cause for the slump. If analysts are to be believed, the cycle seems to have been:

The start was the defaults in the so-called sub-prime mortgage loans in the US, and consequent fall in the prices of credit derivatives and collateralised debt obligations, based thereon, in both the US and Europe.

As is very common, the trend soon engulfed not only high yielding, below investment grade bonds but also other types of debt "" in effect, triggering a flight to quality on the part of investors.

In turn, this meant that the investment banks that had committed to lending money to finance large leveraged buyouts (LBOs), like Chrysler and Alliance Boots, could not downsell the bonds and are having to carry them in their own books. At the heart of risky financing is, of course, the hope, if not the belief, that one would be able to sell the debt to other investors (the "greater fool theory"). Has the music stopped playing? Many institutions are now left with unsalable debt, hidden and not-so-hidden losses (HSBC, Macquarie Bank, American Home Mortgage and so on). The sentiment change has affected even investment grade bonds: global issuance was barely $ 100 billion in July, a third of June, and the lowest monthly number for almost three years.

For some time, private equity-led LBOs, at prices well above the stock market quotations of the acquired companies, had been growing, and underpinned the rising equity prices. The possibility of a slowing in the LBO market, seems to have become a bear influence on equity prices, in the US and Europe.

Coming back to the sharp increase in global M&A activity, the total last year was as high as $ 4.5 trillion, about 20 per cent of that representing private equity-backed LBOs. LBOs became attractive because of the cheap financing such transactions were attracting, with investors falling over themselves to finance ever higher leverage, at ever lower margins. In a matter of five years, the ratio of debt-to-EBITDA has gone up from around 2.5 to around 6.5 recently. And, it has been such a strong borrower's market that much of the debt is described as "covenant lite", an expression that did not exist a few years back "" what it means is that the lenders' bargaining position was so weak that they could not impose tough conditions or events of defaults permitting acceleration of the debt, on the borrowers. The more favourable tax treatment of long-term capital gains on equity, and the tax deductibility of interest on debt, obviously made the game very attractive to private equity. In many cases, their profit came from arbitraging between debt and equity costs, as much as from improving operating efficiencies.

In an era of globalised financial markets, shocks in one get quickly transmitted to other markets as investor sentiment changes. The Indian equity market has had two sharp falls, the first on July 27, and the second on August 1. While there are some signs that global equity markets may be stabilising, to my mind Indian equity valuations probably have more fundamental weaknesses. Firstly, the earnings yield of less than 5 per cent, when bond yields are about 8 per cent, can be justified only by expectations of a continued rise in corporate profitability. Partly as a result of the deflationary measures taken by the central bank (higher interest rates, an appreciating currency), operating profit growth has clearly slowed as witness both Q4 (of last year) and Q1 (of this year) numbers. The net profits have not been affected that badly, thanks to translation gains on foreign currency debt, obviously not a lasting effect. And, once petro-product prices are revised, as they will have to be, sooner or later, the recent fall in the inflation rate may turn out to be short-lived.

Tailpiece: Appropos my article "Cautionary tales from Europe" (July 9), it has since been reported that the Bank of Italy (Italy's central bank) has ordered the entire board of Banca Italease to be replaced. Simultaneously, it has warned some foreign financial institutions to monitor more carefully their sales of complex derivatives which their clients may not understand. Obviously, the old adage of caveat emptor ("Buyer beware") has been expanded to sellers of complex products as well.

avrajwade@gmail.com