• 05 Oct 2012 at 1:59 PM

Dogs Getting More Attractive Financing Than Houses

I guess if you read the jobs numbers today you’d say “huh, the economy is getting a little better,” though there are other avenues you could go down. But if you read that Petco Animal Supplies, where the pets go for their animal supplies,1 sold $550 million of Caa1/CCC+ holding-company covenant-lite PIK-toggle notes at an 8.62% yield2 yesterday to fund a dividend recap, you’d be all “HOLY CRAP I LOVE 2006!”

The Journal article on the latter point takes the view of “some managers are sort of skeptical of holdco PIK-toggle notes to pay dividends to the private-equity owners of pet supply stores,” and, I mean, you can’t blame them (the managers or the Journal), but of course the real story is not “some people didn’t buy some terrible bonds,” which is always and everywhere true, but rather “other people did,” which is less common.

Part of the purpose of the Fed bidding everything government-guaranteed and <=5 years down to a zero yield is to convince / force the investors of the world to start making reckless investment decisions, er, “move further out the risk curve,” because people making reckless investment decisions like “I want to fund a chain of big-box kibble stores” is how we create new productive ventures and Put Our Economy Back To Work™. That and juicing aggregate demand by handing people money, which in America takes the somewhat unintuitive form of (1) lending them money to buy houses and/or (2) convincing them that they have more money because their house price went up.

The Petco part of the strategy is working like a charm. First of all, buying these bonds is just a classically reckless investment decision. Really the recklessness decision checklist for fixed-income investments consists pretty much of:

  • holdco?
  • unsecured?
  • PIK-toggle?
  • use of proceeds is dividend recap?
  • do you sell pet supplies?

So, success. Not only that, though, it’s a virtuous cycle. In some sense you’re an idiot to give money to a risky company, charge them 8.5% interest, and then let them not pay you that interest if things get tough. But in a broader sense, it’s a great idea: if things get tough, Petco is more likely to survive, because (1) their interest rate is relatively low versus historical CCC levels and (2) they don’t have to pay it. Similar things can be said about the continued weakening of covenants: if you don’t have covenants that throw you into bankruptcy when you run into financial trouble, you can run into financial trouble while still avoiding bankruptcy. Part of why high-yield investors are stretching to buy these bonds is that recent and expected default rates are low; easy terms – and expected easy refinancing with low rates forever – are part of why you can expect default rates to remain low.

Meanwhile the other half of the mechanism – cheap mortgages and juiced home prices – is only sort of working. Ryan McCarthy has a nice rundown of the disconnect between (1) the Fed has lowered MBS rates to, like, zero and (2) you still can’t get a mortgage, for a very very metaphorical “you.”3 Basically the answer comes down to a lowering of rates not translating into a lowering of underwriting standards, which in some unexpressed sense is what you want: you want people moving further out the risk curve to capture more yield.

Some of the theory here is frankly mysterious to me. For instance, the Fed directly lowers yields by buying conforming agency RMBS, while those agencies are actually tightening underwriting standards – via stepped-up putback enforcement – in a way that reduces the supply of conforming mortgages. So in some ways that works at cross-purposes, but in another sense both of those things should have the effect of pushing banks (investors) out the risk spectrum in the form of making more non-conforming mortgages (buying non-agency RMBS) to capture higher yields. But in fact while subprime RMBS is booming, pricewise, it is actually contracting, sizewise. Similarly the big Journal piece on putbacks contains this assertion:

Fannie officials also say put-backs aren’t as responsible for tighter standards as lenders suggest. Underwriting criteria for jumbo mortgages are every bit as stringent, and those loans are too large, by definition, for purchase by Fannie and Freddie.

I’m assuming this is just a temporary friction. Who will be brave enough to toss aside Fannie and Freddie and just start making reckless jumbo and subprime loans? Those can’t be that far behind Petco, can they?

But they’re not here yet. And that provides one reason not to get too excited about the Petco deal. Yes it is people recklessly flinging money at Petco, which is great. But they’re not flinging that money at Petco to open Petcos, which is less great, because we need more Petcos for reasons both economic and PUPPIES. They’re flinging the money at Petco to give it back to its private equity investors, who are at a loss for what to do with it.

Investors Jump Off the ‘Junk’ Pile [WSJ]
Counterparties: What’s holding back mortgage lending? [Reuters / Ryan McCarthy]

1. They really do! It is totally adorable. Guys, I cannot lie: I love Petco. BUY PETCO.

2. Bloomberg tells me 8.5% cash-pay or 9.25% PIK, sold at 99.5, which it also tells me is 8.624% YTW (for the cash-pay I mean). Maturity is 5 years, seems to be a free call after 1 year, which is itself quite a bet on rates.

3. Not you, you. You’re still cool. Plus you want a jumbo.

31 comments (hidden for your protection)
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Comments (31)

  1. Posted by Guest | October 5, 2012 at 2:11 PM

    It's moving!

    D. Kneale

  2. Posted by HAM05 | October 5, 2012 at 2:17 PM

    pik toggle? does that mean bonobos are coming back?

    -cautiously optimistic in midtown

  3. Posted by needy guest | October 5, 2012 at 2:18 PM

    where have you been?!

  4. Posted by Coco | October 5, 2012 at 2:20 PM

    Ugly dog

  5. Posted by Bored Guest | October 5, 2012 at 2:21 PM

    Sweet freakin' wheaten.

  6. Posted by Alt_EST | October 5, 2012 at 2:26 PM

    Serious post:

    Just because its non-conforming doesn't make it subprime. The credit window for the Agencies is incredibly narrow at this point. We don't need someone to start making loans to a 580-FICO guy one year out of foreclosure, but we probably do need someone in the marketplace making purchase mortgage loans to the 45% DTI two-income family at 700 FICO that forgot to pay their credit card once last year. There are good credits out there that aren't conforming or are jumbo.

    That said, anyone have a warehouse line for me?

  7. Posted by N'08 | October 5, 2012 at 2:27 PM

    Serious post:

    Anyone know how to train my English Bulldog how to skateboard?

  8. Posted by Fat Cobra | October 5, 2012 at 2:30 PM

    Where's it going?

  9. Posted by Hulk Thermos | October 5, 2012 at 2:31 PM

    Rub some peanut butter on your balls and then meet me at Minetta's.

  10. Posted by HAM05 | October 5, 2012 at 2:34 PM

    avoiding wideclops :(

  11. Posted by Steve | October 5, 2012 at 2:40 PM

    Matt, great article.

  12. Posted by Spiro | October 5, 2012 at 2:54 PM

    I'd hit that.

  13. Posted by E. Cartman | October 5, 2012 at 3:07 PM

    iPhone fat finger down voted you. Apologies

  14. Posted by Dateraider | October 5, 2012 at 3:22 PM

    Mouse-equipped on-the-fencer voted up to compensate. Happy Friday

  15. Posted by guest | October 5, 2012 at 3:23 PM

    Sorry but how is an 8.62% yield "crappy" when real interest rates are negative? Yes, pik toggle, holdco, etc, but I'd say that's covered in the gigantic spread. There's also the (somewhat compelling) argument that if Petco has held it together for the last 4 incredibly bad years for all things consumer-discretionary, there's no place to go now but up.

  16. Posted by Guestest | October 5, 2012 at 4:02 PM

    Matt, how can you afford a Bloomberg terminal?

  17. Posted by guest | October 5, 2012 at 4:03 PM

    Taking on equity-like risk (no covenants, no protection) for fixed-income returns is a horrible risk-return trade.

  18. Posted by irrationalexuberance | October 5, 2012 at 4:03 PM

    Short high yield? Check

  19. Posted by InfiniteGuest | October 5, 2012 at 4:25 PM

    The key assumption here is that dog food prices will never go down.

  20. Posted by Standard&MoodyFitch | October 5, 2012 at 4:55 PM

    Of course they won't, who might think otherwise?

  21. Posted by Phil F. | October 5, 2012 at 5:32 PM

    Very good points, any interest in getting in on the ground floor of the next big thing in wireless?

  22. Posted by Roof Roof Refi | October 5, 2012 at 5:33 PM

    You Bitch.

  23. Posted by LordDeb | October 6, 2012 at 1:35 AM

    Dogs' life…<img src="http://tinyurl.com/d3grdxt&quot; width="1" height="1" />

  24. Posted by WarrenG | October 6, 2012 at 6:03 PM

    The dog has spoken

  25. Posted by new guy | October 7, 2012 at 12:22 PM

    why is holdco a minus?

  26. Posted by Guest | October 8, 2012 at 12:53 AM

    Because it leaves a creditor structurally subordinated to opco creditors. Opco is typically where the cash flow and assets are located, so as a holdco creditor you're relying on dividends (i.e., equity) from opco to pay you back. Someone with a background in bankruptcy law or distressed debt could walk through all the specifics and exceptions, but that's the summary version.

  27. Posted by Guesto | October 8, 2012 at 4:17 PM

    Thats not a Wheaton, its a Labradoodle (or Goldendoodle) brah, apparently with no ears…..

  28. Posted by Darell Francis | October 11, 2012 at 3:54 PM

    this is pretty interesting

  29. Posted by Home Page | October 15, 2012 at 3:40 AM

    As a Newbie, I am permanently exploring online for articles that can aid me. Thank you

  30. Posted by canine therapies | July 22, 2013 at 12:01 PM

    Just because its non-conforming doesn't make it subprime. The credit window for the Agencies is incredibly narrow at this point

  31. Posted by Benjamin | February 10, 2014 at 3:15 PM

    I’m assuming this is just a temporary friction. Who will be brave enough to toss aside Fannie and Freddie and just start making reckless jumbo and subprime loans? Those can’t be that far behind Petco, can they?