"Killing the goose that laid the golden egg"

The golden egg in this case is cheap financing. Ample liquidity and low interest rates have buoyed most asset classes over the past few years. The corollaries of this have been low volatility and plentiful access to low cost debt, which in itself has helped default rates fall to very low levels. If you think about it, you only go bust if you run out of money, and so long as you can refinance you won't run out of money. So much the better if you can get all the finance you need at lower rates than you were used to paying.

The chart below shows how debt costs for an average B-rated European corporate have evolved since the end of 1998.

It looks as if we are in a Panglossian world. However, greed may get the better of financial markets: instead of enjoying the status quo, corporate financiers (investment banks and major companies) become ever more audacious, introducing increasingly leveraged, subordinated or tortuously structured financings. At the same time, investors starved of yield and lulled into a false sense of security by low volatility and defaults take on increasing risks. Inevitably, when sentiment turns or there is a shock, liquidity evaporates, defaults rise, debt costs soar and investors, advisers and companies alike are left wondering what went wrong.

Although the above chart looks at trends in sub-investment grade credit, the same trends are evident (less extremely) for investment grade credit costs and risks. And it is in investment grade land where the seeds of disaster may be sown. First of all, if you can finance yourself as a highly leveraged B-rated company at 8% (as shown by the purple line in the chart above), versus, say, 5% as a moderately indebted BBB+ company, why wouldn't you at least think about it? Because just thinking about it is enough to send spreads sharply wider. If the directors don't have the nerve to do it themselves, those kind private equity people can always appeal above their heads to shareholders with a leveraged bid promising an instant cash windfall.

At this point, the former shareholders don't need to care about leverage, having most likely sold their shares at a tidy profit. 

Below is an example of how leveraging up can transform returns,

Problems only arise if profits unexpectedly decline or interest costs escalate. Stress tests show what happens under the two structures if EBITDA falls by a third and interest costs rise 2%. In the base case, shareholders' gain is debtholders' pain. In the stress scenario above, bondholders suffer further losses, but shareholders' investments are likely to be wiped out or, at the very least, bondholders will be calling the shots. Higher borrowing costs generally, and tighter controls on borrowers are likely to result, potentially constraining shareholder returns market-wide.

Another example of audacious financing is the new phenomenon of "corporate hybrids". These are perpetual bonds whose coupon increases after a set period if the bonds are not called (repaid by the issuer), and can be deferred if no dividend is paid. The worst example is Thomson SA. It pays 5.75% until 2015, and steps up by another 1% in 2015 if not called. The good news is, if there is a change of control, the coupon increases by 5%, to 10.7%. The bad news is that the coupon can be omitted if no dividend is paid, and coupons are non-cumulative. How easy would it be for a private equity investor to buy the company, waive the dividend and avoid paying the coupon (i.e. getting free debt) for, say, five years, then redeem the debt at par, returning all the interest saved (plus enough to compensate for all the dividends omitted) to shareholders? No wonder when Thomson's profit unexpectedly missed forecasts, making the group vulnerable to an LBO, hybrid bondholders were sitting on a 23% capital loss within five months of issue. 

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