Bond market says deal will close at $42.75BOYD ERMAN
21:55 EST Sunday, Feb 03, 2008
When it comes to the chances of the $35-billion BCE Inc. buyout falling through, the bond market isn't buying what the equity market is selling.
Many stock market investors clearly believe the deal is likely to fail. The stock finished Friday at $36 on the Toronto Stock Exchange, well below the $42.75 that Ontario Teachers' Pension Plan and its partners agreed to pay last June before global markets went haywire.
The main reasons for the jitters are the possibility that the lenders funding the deal will back out, and that a bondholder court challenge will succeed in stopping the buyout.
Those in the bond market, on the other hand, are much more convinced the transaction will close later this year.
According to the credit-default swaps (CDS) market, an influential backroom of the financial system where big bond investors place bets, there's at least a 70-per-cent chance that the deal succeeds.
The CDS market is little known on Main Street, but at about $45-trillion, it rivals the size of all the world's stocks combined.
A product of the derivative age, the market is where bondholders go to buy insurance against companies defaulting on debt.
Like insurance for any other event, the price rises along with the likelihood of a claim. Just as collision coverage costs more for bad drivers, insurance against default costs more for a company with a debt-laden balance sheet.
For BCE bonds, CDS insurance is very expensive, costing more than six times as much as insurance against default by peers such as Telus Corp. and AT&T Inc.
BCE's balance sheet isn't debt heavy now, but it will be if the takeover succeeds, because the buyers plan to load the company up with $27-billion of new loans.
CDS prices are near “levels that are all-time highs for BCE bonds, which is indicative of the fact that the credit market still expects that BCE will be a highly leveraged entity and therefore the deal will be consummated,” said Dan Barrett, an analyst in New York at Tradition Group, a broker of credit default swaps and other derivatives products.
As the CDS market has grown, so has its reputation as a leading indicator for leveraged buyouts, often showing moves well before the equity markets catch on.
During the LBO boom of recent years, when speculation grew around a target company, default insurance prices would rise as concerned bondholders flocked to buy.
It usually wouldn't take long for the stock market to catch on, starting a run in the target's stock.
“The equity guys would see what was going on in the bond markets and say ‘Aha, maybe we should start buying the stock,'” said Société Générale credit strategist Suki Mann.
A 2006 study by Credit Derivatives Research LLC showed that credit insurance prices on bonds of 30 takeover targets – among them four of the biggest LBOs of 2006 – rose before word of potential deals showed up in the media or were officially announced.
The CDS market gave early warning of deals for Freescale Semiconductor Inc. and Harrah's Entertainment, according to the report.
The early moves were so bang on they even drew the attention of regulators such as the U.K.'s Financial Services Authority.
The question is, will CDS prices be as reliable now that the LBO boom is over, or is the stock market right about BCE this time around?
“I'd say trust the CDS market,” said Tim Backshall, chief strategist at Credit Derivatives Research, arguing the CDS market is the preserve of institutions, with little of the “euphoria and dysphoria” that comes with retail investors.
Also, the bond market is where the funding for the BCE deal must eventually come from, making the CDS market “closer to financing sources.”
Mr. Barrett also believes the CDS market is a better barometer.
For one, he reckons bond investors have the best handle on the chances that the court challenge by bondholders will succeed.
On top of that, he said the price of insurance against BCE default may be high because lenders such as Toronto-Dominion Bank and Citigroup may be buying protection for loans they promised to help Teachers buy BCE.
And the banks wouldn't bother buying insurance if they didn't plan to make the loans.
“The commercial banks are the largest players in the CDS market,” Mr. Barrett said. “What we tend to find in a lot of these transactions is banks that are part of the financing tend to go in the market themselves and buy protection on their financing lines.
“In other words, they who know much, much more than we do about what's happening behind the scenes, have either approved the financing or are going ahead with the financing they have already approved.”
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