Beware: Credit Markets Are Getting Risky Again

Risky lending practices may already be creeping their way back onto Wall Street. Investors' pursuit of higher yield has led to a doubling in issuance of both investment- and speculative-grade bonds and loans in September, to $138 billion. Research from Standard & Poor's suggests that while that jump is a positive sign that credit markets have stabilized, it also signals that credit standards may be softening more quickly than is prudent.

The primary market for bonds and loans was averaging about $75 billion per month through August before its September spurt, according to S&P. The steady inflows of cash into bond funds and exchange-traded funds have also helped fuel the market. According to Dealogic, junk bonds have enjoyed a particularly vibrant resurgence: a record-breaking $275 billion in new issuance worldwide in the first three quarters of 2010, up from $163 billion during the same period last year.

Risk Is "Firmly on the Radar"

Diane Vazza, head of S&P's Global Fixed Income Research, said in the report that part of the volume increase stems from companies' ability to negotiate slightly looser covenants on term loans and fewer concessions on new debt issuance. "The strong investor demand for corporate bonds and loans has given issuers a bit more power to demand better terms," said Vazza.

As a result, she projected that, "It is possible that we will see a rise in risky deals, such as weaker companies funding dividends and acquisitions through debt offerings and an increase in leverage in LBO [leveraged buyout] deals. While we have yet to return to pre-recession excesses, investors' search for yield has put some of these risks back firmly on the radar."

S&P research suggests that with credit standards softening, more companies are starting to take on debt while it's cheap, regardless of whether such a move is critical to performance. Recently, AAA-rated Microsoft (MSFT) raised nearly $4.75 billion through debt issuance -- even though it had $37 billion in cash and short-term investments on its balance sheet. Many stronger companies have also taken on debt to finance share buybacks in an attempt to improve their stock performance.

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Other trends that suggest risk is making a comeback in the credit markets include the sharp increase in leveraged loans (loans to companies with less-than-stellar creditworthiness) and the issuance of speculative-grade bonds, a.k.a. junk bonds. Through the first three quarters of 2010, leveraged-loan volume has jumped to $162 billion from $50 billion during the same period in 2009. Also, speculative-grade bond issuance among nonfinancial companies will surely set an all-time record this year. Already, nearly $120 billion of junk has been issued through the first three quarters of 2010, almost equal to the record $121.8 billion issued in all of 2007.

If credit trends continue to move in these directions, Vazza said it could be cause for concern. After all, a race to the bottom in credit standards was a primary spark for the financial meltdown that followed shortly after 2007's record-setting issuance.