Why a Walgreens Buyout Could Stink for Corporate Bond Investors

Two events in credit markets this week show how late-cycle corporate bond investing can be so challenging. First news that Walgreens Boots Alliance (WBA) is considering going private, which would be the largest leveraged buyout (LBO) in history. Second is news that Xerox (XRX) is considering buying HP  (HP) . Both Walgreens and HP bonds dropped substantially on the news. Here are some thoughts on what this says about where we are in the cycle and how to avoid troubles like these in your positions.

Leveraged-Buyout Company's Appear Like Safe Credits

LBOs are the No. 1 nightmare for investment-grade credit analysts. In an LBO, a company uses debt to buy out existing shareholders, generally winding up with a capital mix with much more debt and much less equity. So obviously that scenario is bad for the pre-LBO bond holders, who wind up holding a company with vastly more leverage. But LBOs are particularly insidious, because of the kinds of companies involved.

To see why, consider what ingredients you need to make an LBO work. You need a low current debt burden, otherwise the company can't take on all that LBO debt. You need stable cash flow, otherwise the deal would be too risky for the private equity firms. Generally they are companies in very established business lines, because fast growing companies are already making plenty of return on equity without the risk of a huge debt burden.

But what do credit investors like to see from an investment-grade bond? An established, stable company with steady cash flow and a low debt burden. So exactly the kind of safe bond you'd want to buy is also exactly the kind that could pull off an LBO.

Walgreens Boots is exactly this kind of company.

Same Story With HP

There are a few reasons why companies wind up doing LBOs, but they generally boil down to one thing. The company isn't growing enough to satisfy shareholders, so management -- or a private equity firm -- decides they can engineer a higher equity valuation. Again, Walgreens fits this story well. Prior to the LBO rumors, the stock was down 32% unannualized over the last three years and just under 20% year-to-date. This is vs. the S&P 500 that's up 56.5% and 22.7% year-to-date.

While the potential HP/Xerox deal isn't a LBO per se, it has all the same markings. Both have badly underperformed their tech peers in recent years, especially HP, which has tried a number of machinations to improve shareholder value with little to show for it. When one slowly growing firm buys another, it almost always involves a substantial amount of fresh debt.

Both bonds have declined in value substantially, with the yield on both rising 40bps-50bps vs. Treasuries. Granted that isn't the end of the world, but in both cases the resulting price loss was greater than two years' worth of yield advantage over Treasury bonds. You thought you were buying safety, now it will take a long time to make up your losses. In addition, I'd bet that if these deals actually get done, there is substantial additional losses coming. In Walgreens' case, that's probably 6%-8% more.

This Is Classic Late-Cycle Behavior

If Walgreens were to consummate the LBO, it would probably be the largest since the infamous TXU Energy LBO. That one was announced in February 2007, darn close to the top of the market.

Generally, drawing these kinds of comparisons is lazy analysis. Just because large-scale leveraging transactions start or start picking up definitely doesn't mean we're near a market top. But this is classic late-cycle behavior. When you are early in the cycle, firms usually have an easier time growing their earnings organically. When you are mid-cycle, lenders have lots of projects to lend to, so getting a mega deal accomplished is harder. Only at the end of the cycle when everyone is struggling do you see these kinds of deals happen.

I have no idea how long this part of the cycle lasts, but we're definitely in the late innings.

Corporate Bonds Are Full of Landmines Now

This makes investing in corporate bonds tricky. Whatever balance sheet looks great today could be tomorrow's LBO. And when you are investing for safety, you don't have enough margin for error to deal with the kinds of price losses that come with huge leveraged deals. Here's how to avoid the landmines:

• Buy bonds for companies that are already levered. Look for bonds where the company just did a deal that increased leverage and have pledged to move leverage lower. These kinds of companies don't have the capacity to suddenly increase debt. The risks you know about are always better than the ones you don't.
• Look for companies where the stock has outperformed. Most big leveraging transactions happen when shareholders are putting pressure on management. This tends not to happen with companies where the stock is outperforming.
• Find change of control covenants. This is rare with investment-grade companies, but does sometimes exist. If structured right, a change of control covenant would force the company to buy out existing bond holders before doing a LBO.
• Buy low dollar price bonds. When a company is investment-grade, investors focus solely on the yield of the bond. The dollar price doesn't matter much. In other words, two bonds from the same company with similar maturity will have the same yield. The market won't care if that yield results in a dollar price of $98 for one and $112 for another. But if the company goes to junk-rated, which always happens after an LBO, investors will care. The high dollar price bond winds up much worse for investors in bankruptcy, and therefore as it moves from very safe pre-LBO to quite risky post-LBO, the bond that was initially $112 bond will far underperform the $98 bond.

Beware of the Hold-to-Maturity Trap

Often when confronted with these kinds of sudden losses, investors console themselves by saying "If I just hold the bond to maturity, I get my money back anyway." So this loss isn't actually important." That's a bad way to think about it. A 2019 paper by two Cal Tech researchers showed that LBOs default at a 20% rate over 10 years. And since bond holders in a LBO tend to become subordinate to the loans made as part of the LBO deal, they often get nearly wiped out completely in the process.

Let's say that Walgreens bonds would yield about 5.7%, which is the average for B-rated companies. So the right way to think about a bond post-LBO is "From this moment on, I will make 5.7% on this bond per year if all goes well. I also now have a 20% chance of a -100% return." Do you like those odds? It is a lot of risk to take on to make what is still a pretty paltry return.

At the time of publication, Graff had no position in the securities mentioned.