End of the affair

SERIOUS MONEY:Patrick Kavanagh began Advent, one of his most enduring poems, with the line, "We have tested and tasted too much, lover."

Almost 40 years since his death and the opening words of the famous poem seem an apt description of investors' love affair with risky debt of all varieties. Credit markets have been ripe for a setback for some time.

Indeed, Ben Bernanke, chairman of the Federal Reserve, warned of the same just weeks ago but investors paid no heed. They were sadly mistaken as the slow train wreck apparent in America's mortgage market finally reached the corporate credit markets.

The price of credit has soared in recent weeks as the irrational pricing of high-risk debt instruments is being eradicated. High-yield bonds suffered their second worst weekly performance in the market's history and the additional yield offered versus US treasuries has jumped by roughly 170 basis points to more than four percentage points since the turmoil began.

Meanwhile, the leveraged loan market shut down as the leveraged loans of Alliance Boots and Chrysler failed to be syndicated.

It is not too difficult to understand the underlying fundamentals that have contributed to the recent turmoil.

Investors of almost every variety suffered in the aftermath of the stock market collapse precipitated by the dotcom euphoria. Pension funds came under intense pressure as overweight equity positions reduced the value of assets while lower long-term interest rates increased the present value of future liabilities.

The search for high-yielding assets in a low-return world began, which shifted the balance of power in credit markets from investors to borrowers.

The unprecedented demand for higher-yielding debt instruments contributed to a surge in supply.

Leveraged loan new issuance soared from $218 billion (€159 billion) in 2001 to $612 billion last year, while high-yield new issuance jumped from $83 billion to $178 billion over the same period.

Despite the tremendous increase in supply, investors' clamour for risky debt meant new issuance was easily absorbed. Indeed, yield spreads moved to historic lows while debt-to-cash flow multiples on leveraged buyout deals edged ever higher.

Robust demand contributed not only to pricing that did not seem to compensate investors for the additional risk but also a serious decline in the level of protection embedded in leveraged loan facilities.

According to a recent report by the ratings agency Fitch, the percentage of leveraged loans containing a coverage covenant of any kind dropped to 44 per cent last year as against a long- term average of 68 per cent.

The percentage of loans containing a leverage covenant dropped to 51 per cent in 2006, well below the historic average of 73 per cent. The broad-based decline in protective covenants continued during this year's first half as the new issuance of "covenant-lite" loans that typically contain no covenants at all soared to more than double the issuance for all of 2006.

Excessive pricing and declining levels of embedded protection have been accompanied by a sharp increase in the proportion of new issuance attributable to the lowest tiers on the credit rating structure.

Single-B and lower-rated loans accounted for almost two-thirds of new issuance during the first five months of this year.

In other words, the sins apparent in the mortgage market are equally applicable to corporate debt as even the most dubious corporate borrowers found it relatively easy to secure an ample supply of credit.

The balance of power has finally shifted back to investors. The persistent deterioration in America's mortgage market, combined with the need to place an immense leveraged loan pipeline of more than $200 billion, has led to a widespread reassessment of risk.

The fact that today's credit markets are dominated by non-bank investors such as hedge funds, with short-term performance goals, means that the current repricing of risk to more appropriate levels is likely to persist.

The perennial optimists in financial markets have declared that this is a healthy correction in an ongoing bull market, pointing to the fact that the credit markets have weathered previous storms such as the downgrading of Ford and General Motors in 2005 or the Amaranth hedge fund collapse last year, with little more than a hiccup.

They are likely to be proved wrong as the current episode is happening amid a deteriorating economic picture. Although the American economy rebounded during the second quarter and recorded a respectable 3.4 per cent rate of growth, the composition was less than inspiring. Growth of no more than 2 per cent or perhaps worse seems likely for the remainder of the year, hardly an environment conducive to excessive risk-taking.

Easy money has a nasty habit of creating difficult problems. The blue-sky merchants argued that difficulties in the mortgage market would be contained and have been proved wrong.

The argument that the current turmoil is nothing more than a healthy correction is eerily similar.

Investors would be well-advised to heed the words of John Maynard Keynes: "When the facts change, I change my mind. What do you do, sir?"

charliefell@sequoia1.ie