Friday, July 18, 2014

Thoughts on Private Equity and High Yield Bond Duration in Latest Horizon Kinetics Quarterly Letter


"If one reviews some broadly representative bond indexes, like the iShares Core Total U.S. Bond Market ETF (AGG), which emulates all the investment grade bonds in the United States, one will find that the average maturity is not much longer than six years. Or, taking the iShares iBoxx $ High Yield Corporate Bond ETF, the average maturity is just over four years.

In other words, even though there are buyers of 30-year bonds, looking at the bond market as a whole, it is clear that very few are interested in taking duration risk. Everyone is aware of the interest rate risk, and they are preparing for it. Bond buyers, especially those taking credit risk, certainly do not want to add duration risk.

However, there is one group taking the risk, but it just does not realize it. In that group are those institutions — and they are only institutions — that are placing large amounts of money in private equity. They think they are lowering risk. They are removing money from publicly traded equity, and even bonds in some cases, and placing it in private equity.

Of course, private equity is borrowing the money because it is only private equity in name. A more functionally accurate term would be leveraged equity. The idea behind buy-out private equity investing is to find a suitable public company, pay a control premium for it, and then bring it private with an extraordinary amount of debt. If the maturities on those borrowings are short (and, unlike the historical norm, there is much less availability of long-term high-yield lending to match the extended workout periods ordinarily required for private equity) and if interest rates rise, then the refinancing risk is entirely on the private equity investor. The bond buyer, assuming the company remains solvent, is going to get a higher coupon; the private equity investor is going to pay the higher coupon."

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