HOW THE COMING LBO BOOM WILL AFFECT YOUR BONDS

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1 FIXED INCOME HOW THE COMING LBO BOOM WILL AFFECT YOUR BONDS Krishna Memani CIO Fixed Income Wall Street s animal spirits are coming back, judging by the amount of leveraged buyout (LBO) activity across the industry. Already in 2013, several large capitalization corporations have been approached as potential targets. The specific reasons for the buyouts vary. In the case of the computer company Dell, 1 the company s founder and largest shareholder, Michael Dell, has joined with partners to make a bid so he can engineer a corporate turnaround. Liberty Global, 1 a media company with subsidiaries worldwide, has a strategic interest in joining forces with its target, Virgin Media, 1 a UK provider of telecommunications video and broadband Internet. In the situation with ketchup-maker Heinz, 1 Warren Buffett and his partners believe they can run the firm more effectively than the existing owners. But while the rationale for the buyout may differ, the plan is basically the same. The acquirer will likely increase the amount of debt on the target company s balance sheet in order to help finance the purchase price and enhance their own potential long-term gains. EXECUTIVESUMMARY Signs point to a resurgence in leveraged buyout activity. In the past, LBOs have had a major impact in both investment-grade corporate and the senior loan markets. LBOs, in general, hurt investment-grade corporate bonds while often increasing the supply of attractive senior loans. u The return of the LBO Borrowing costs are low, and there are dozens of cash-rich, high quality firms that could make attractive LBO targets. u LBO bond impact Bond investors can be hurt significantly when the company they own bonds in is the target of an LBO. u Being vigilant There are several strategies bond investors can employ to potentially take advantage of or avoid the impact of LBOs. Not FDIC Insured May Lose Value Not Bank Guaranteed INSIGHTS

2 Much of the investor and media focus on these and other LBOs has been their effect on equity prices. That s reasonable since an LBO can provide a big pop to a target firm (Dell s stock rose nearly 13% the first trading day after LBO talks were made public). But fixed income investors should pay a lot more attention to what happens to the debt of LBO targets. As you ll see, they often have a negative effect on investment-grade credit. But they also could have a less-noticed positive influence on the senior loan market. Indeed, barring a major change in interest rates, we believe LBOs will be one of the largest factors impacting the domestic fixed income universe for the foreseeable future. Why Buyouts are Back The reason that these deals are taking place is that the current market environment for these types of transactions is as favorable as it has been since early Borrowing costs are extremely cheap thanks to the accommodative monetary policy of the Federal Reserve. Market volatility is low too, as investors worry less about the potential damaging effects from the European recession, a slowdown in China s economy, and the ongoing U.S. fiscal debate. At the same time, demand in the senior loan market (also known as the leveraged loan market) is extremely robust as investors continue to scour the globe in the great search for yield. Private equity funds also have an incentive to do deals. They are sitting on billions of dollars given to them by investors that is reaching the end of its holding period and therefore needs to be invested or returned. While the private equity groups may need to provide more equity than in the past, the combination of low valuations and low funding costs increases the likelihood of deals being completed. As it currently stands, these favorable trends in the buyout world are likely to continue into the foreseeable future. What type of company makes a good acquisition target? There is no golden rule, but many potential targets do share some common traits that make them attractive. Firms with low existing levels of leverage (low debt), cash rich balance sheets, high free cash flow, lots of tangible assets (such as real estate), and an underperforming stock price (or, at the least, a low P/E multiple) can make attractive candidates. Investors believe that it is possible to improve the performance of these companies by reducing costs, divesting assets, or both. Because of the additional leverage piled onto the balance sheet, profits to the new owners are magnified, making the transaction economically attractive. This year, many Wall Street investment banks have issued watch lists of potential targets that range anywhere from 50 to 100 potential target firms. But with credit as cheap as it is, many companies that may not meet the traditional definition of a target may soon find themselves in the middle of a buyout (Heinz being one example). 2

3 LBOs Can Hurt Investment- Grade Bonds LBOs are typically debt-financed acquisitions by a private consortium of investors. This is usually a positive catalyst for the equity holders of a corporation as most transactions are executed at a premium to the company s current stock price. However, this is not usually the case for the company s bondholders. Generally, as dealmakers feel they can take advantage of the relative mispricing between debt and equity capital, they use leverage to finance these types of transactions. Using debt as opposed to equity may potentially offer investors some distinct advantages. It minimizes the amount of equity needed to purchase the target, which could maximize profits for the owners should the deal turn out to be successful. In addition, debt capital enjoys favored treatment according to The threat of an LBO is something we believe investment-grade bond investors need to take into account when surveying their holdings. U.S. accounting standards as interest expense is tax deductible, and in most cases less expensive than equity capital. But while LBOs are typically positive for equity shareholders they can be quite the opposite for existing bondholders of the LBO target. Bondholders are left holding paper of a company that suddenly has a significantly higher level of debt on its balance sheet. In most cases this leads to a decline in value of the bonds and downgrades by the credit rating agencies. An academic study that looked at LBO transactions from 1980 to 2006, concluded that the mean return of a bond from one month prior to the LBO announcement to one month after the announcement was 4.9%. 2 That figure may be unsettling to any bond investor, but in our view the current environment could make things even worse. With rates near historic lows, many investmentgrade bonds are currently trading 3 INSIGHTS

4 significantly above par, which increases the magnitude of potential losses for investors. Bonds that aren t trading well above par likely do not have high coupons, so even a small decline in price can have a significant impact on the value of the investment. Chart 1 is an example of what can happen to the equity and bond prices of an LBO target. In May of 2007, Texas Pacific Group and Goldman Sachs Capital made an offer to take telecommunications company Alltel Corp. 1 private. As one can see, the results were very different depending upon whether you owned the equity or debt of the company. A Senior Loan Silver Lining? Although LBOs are not a positive for investment-grade bond investors, they do not necessarily hurt all parts of the fixed income universe. Indeed, they might help one of fixed income s more attractive sectors: senior loans. Loans currently offer attractive yields relative to treasuries and investment-grade debt. These loans are senior in the capital structure, feature a floating rate coupon that resets with short-term rates, and are typically collateralized by assets of the issuer. As treasury rates rose in the first two months of 2013, investors piled into the senior loan market. Unfortunately, this increase in demand has led to a recent wave of repricing across the market, which has reduced the interest rate that investors receive. Chart 1 The Effect of an LBO on Debt and Equity In the days leading up to and the six months after a leveraged buyout offer was announced, Alltel s stock rose about 20% while the price on its 10-year corporate bond fell about 19% LBO Announced on May 21, Stock Price ($) Bond Price ($) /07 2/07 3/07 4/07 5/07 6/07 7/07 8/07 9/07 10/07 11/07 Alltel Common Stock Alltel Corporate Bond 6.5% 11/1/13 Source: Bloomberg, 3/21/13. The mention of specific companies does not constitute a recommendation by OppenheimerFunds. Past performance does not guarantee future results. 4

5 This is where LBO s increased activity may help. To finance the LBO, firms often issue senior loans. This increased supply may help to neutralize the current supply/demand imbalance. As Chart 2 shows, primary loan issuance through the first two months of the year is off to its best start in several years. Some of that increase is attributable to LBOs that happened in the latter parts of This trend could help blunt the current wave of repricing activity in the market. Another benefit is that many of these newly LBO d companies turning to the loan market have stable cash flows, which is an attractive feature for debt investors. Generally speaking, waves of LBOs bring larger, higher quality companies to the senior loan market. Chart 2 Senior Loan Supply Is on the Rise A resurgence in merger activity, demand for higher yielding investments and other factors have contributed to the increase in primary senior loans issued. $155.1 $ $ $59.8 Billions $ Jan/Feb 2010 Jan/Feb 2011 Jan/Feb 2012 Jan/Feb 2013 Source: Credit Suisse, 3/21/13. Past performance does not guarantee future results. 5 INSIGHTS

6 Adjust Your Bond Portfolio The threat of an LBO is something we believe investment-grade bond investors need to take into account when surveying their holdings. For investors that are mandated to own investment-grade corporate bonds, or for investors who are simply looking for lower volatility, there are several ways to position a portfolio to help protect against the risk of an LBO-influenced downturn. Investing in the debt of financial companies is one strategy. Because banks and other financial institutions have very strict regulations surrounding the use of leverage (and even stricter since the financial crisis) they are poor candidates for LBOs. Another strategy is to invest in companies with lower credit quality. In most cases, these firms are not particularly attractive buyout targets; they already employ leverage on their balance sheet which makes adding additional debt a relatively unattractive proposition. Bond investors also should identify companies whose bonds feature a change of control covenant. A change of control covenant allows a debt holder to sell a bond back to the issuer at a set price. In most instances, this price is 101. The current average price in the investment-grade corporate market is about An investor could lose some value The current market environment for LBOs is as favorable as it has been since early on the bond, but the losses could be capped by the put price. Another option is to look for recently issued bonds, as their price is usually trading closer to par. Finally, investors can look to the senior loan market. Currently loans offer significantly higher yields than government securities or investment-grade corporate bonds and the prospects of default are at, or near, all-time lows. We believe the additional supply of loans backed by stable, large, high quality companies created by the LBO process is a healthy dynamic for the loan market and should slow the recent tide of repricing that is negatively affecting investors. Barring a major change in interest rates (via Fed policy or the markets) LBOs are one of the largest risks to investors in the investment-grade universe, but risk in one sector of the market can very well provide opportunity in another. 6

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8 ContactUS Krishna Memani CIO Fixed Income Krishna Memani oversees the firm s fixed income teams and is a portfolio manager on several fixed income strategies. Krishna has specialized in fixed income since Visit oppenheimerfunds.com Call Visit oppenheimerfunds.com Call Scan this code to learn more about us: Search Google Currents for OppFunds to access our timely thought leadership Visit blog.oppenheimerfunds.com Follow us: 1. The mention of specific companies does not constitute a recommendation on behalf of any fund or OppenheimerFunds. 2. Source: Billett, Matthew T., Jiang, Zhan and Lie, Erik. The Role of Bondholder Wealth Expropriation in LBO Transactions (3/08). Past performance does not guarantee future results. 3. Source: JPMorgan Research 2/1/13. Past performance does not guarantee future results. Special Risks Fixed income investing entails credit risks and interest rate risks. When interest rates rise bond prices generally fall and a fund s share prices can fall. Senior loans are typically lower rated (more at risk of default) and may be illiquid investments (which may not have a ready market). Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the open of business on May 1, 2013, and are subject to change based on subsequent developments. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling CALL OPP ( ). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. Two World Financial Center, 225 Liberty Street, New York, NY OppenheimerFunds Distributor, Inc. All rights reserved. DS June 7, 2013