A report by Bear Stearns suggests that investors protect against leveraged buyout risk by buying single name protection on certain credits and moving into nearer term maturities. "We expect there will continue to be market speculation over potential LBOs, along with volatility in the credit spreads of the supposed targets, and thus there will be some associated pressure on spreads," said Victor Consoli, senior managing director at Bear Stearns.
Bear Stearns' defensive strategy includes buying protection on a basket of single name credit default swaps, Consoli said. As an example, Consoli said a $1 billion portfolio could set aside 1%, or $10 million, in CDS protection at 60 basis points. If a manager buys a basket of 30 potential LBO names, all that needs to happen is two of the 30 end up targets of a LBO rumor. Spreads will widen and the protection will kick in for around $10 million, recovering protection on the investment. He advises buying credit default swap protection in the range of 60-120 bps.
Another strategy is to swap into near-term maturities, switching from a five-year maturity to a three-year or lesser maturity and swapping into credits that are not on Bear Stearns' LBO quantitative screens, said Consoli.
Bear Stearns has identified nearly 40 companies that may be at risk for leveraged buyout activity heading into next year. Large name companies that are candidates to be targets in 2006 include General Mills, Conagra Foods, Xerox, Dillard's, Clear Channel Communications, Mattel, H.J. Heinz, Viacom, Staples, AutoZone, Gap Inc., Radioshack and Lear Corp.
Along with LBO activity, the rise of default rates is also expected to continue into 2006 with the worst hit coming to CCC rated credits. "Although BBs make up 50% of the high-yield market, we expect BBs only to see 30% of the defaults, whereas CCCs, which are 18% of the high-yield market, could bear 40% of the defaults," Consoli commented. Analysts at Bear Stearns said that a default rate of 4% is not out of the question for 2006.