David Berman, Financial Post
Whether you were hoping for a decisive rebound in the stock market or fearing another devastating sell-off, the S&P/TSX composite index delivered both yesterday.
After plummeting 400 points on Tuesday, the benchmark index recovered 138 points first thing yesterday morning but subsequently dropped 256 points. It then bounced back and ended the day at 14,105.32, up only 37.16 points.
If you are looking for an explanation for the sudden surge in volatility, you’ll have to look beyond Canada’s borders and gaze upon the credit drama unfolding in the United States, where big-name debt offerings are being yanked.
“We are on the same planet,” said Clement Gignac, chief economist and strategist at National Bank Financial, pointing to the fact that the mergers-and-acquisitions boom that has been stoking Canadian stocks this year relies to a large extent on credit conditions elsewhere.
In the United States, cracks began to appear about a month ago, when investors balked at a number of high-yield debt offerings that typically follow private-equity takeovers. (Essentially, private-equity firms finance the buyout of companies by issuing bonds through investment banks.) Debt offerings from U.S. Foodservice, ServiceMaster Co. and Thomson Learning, worth billions of dollars, hit a wall.
Now, investors continue to raise their noses at anything that looks a tad risky, raising the possibility that surging M&A activity could be sputtering. According to Bloomberg, at least 35 different borrowers have either cancelled, postponed or restructured debt sales recently.
Yesterday, bankers involved in selling debt to finance Cerberus Capital Management’s takeover of Chrysler postponed the sale of US$12-billion worth of debt. As well, Kohlberg Kravis Roberts & Co.’s buyout of Alliance Boots PLC hit a snag when banks delayed the sale of US$10-billion of bonds until conditions improve.
This week, Allison Transmission, a unit of General Motors Corp., postponed a US$3.1-billion debt offering that was part of a leveraged buyout by Carlyle Group and Canada’s Onex Corp.
In the glory days of the buyout boom, this would not have happened. Investors snapped up new high-yield bond offerings without hesitation because they loved the fact they yielded more than safe corporate bonds and ultra-safe government bonds.
But the yields on government bonds have risen in recent weeks, making them more attractive. As well, the fallout from the U.S. subprime mortgage market — in which defaults are surging on mortgages held by consumers with riskier credit profiles — has already sunk two Bear Stearns hedge funds and there could be more turmoil ahead.
Many investors are naturally recoiling at the thought of entering the high-yield debt market just as it appears to be wobbling. Or, at least, they are demanding higher yields to offset what looks like rising risk.
As a result, the yield on high-yield bonds is increasing fast. According to Bill Gross, chief investment officer at Pacific Investment Management Co., those yields have risen to nearly 10% from about 7.5% a few months ago.
“The cost of capital is on the rise suddenly for M&A deals,” Mr. Gignac said. “When 35% of the M&A deals have been done by private equity and cost of capital is on the rise, you scale down the leverage. It’s possible that some takeover announcements will never come true.”
According to Scotia Capital, Canada has a 10% share of the total value of announced buyout deals this year, a startling number given the small size of its capital markets. This buying frenzy has contributed a great deal to the rise of the S&P/TSX composite index this year. The sputtering frenzy is now contributing to its volatility.
