Hungover in Israel's Bond Market – and Partying On

Still suffering the aftermath of the last big bond orgy, investors are getting back into bed with the same dubious sorts.

A funny thing is happening on the way to the bailout. While some bondholders are in wrenching talks with Nochi Dankner’s IDB Holding Corp. and others are fighting with Bank Hapoalim over who gets control over Motti Zisser’s Elbit Imaging property empire, other institutional investors are piling into new debt issues.

In other words, even while the market is still suffering the hangover after its last big bond orgy, it's starting to party again with the same dubious sorts. And investors haven't even learned to demand adequate reward for the risk they're taking.

For nearly all of last year, the corporate bond market was dead in the water. But over the last fourth months, institutional investors – the bodies that invest your savings, mostly mutual funds – have bought around NIS 13.5 billion in newly issued bonds. That's equivalent to half the amount raised in the rest of 2012. The Tel Aviv Stock Exchange’s bond indexes have climbed to record highs as investors embrace new offerings.

But an S&P Maalot report this week profiling bonds issued in February shows how problematic they are. One reason is that as the market heats up, lower-rated companies are pouring in.

Blue-chip issuers are offering nothing more by way of assurances than financial covenants; for instance, restrictions on dividend payments and full repayment if ownership changes. The lowest-rated issuers have no choice but to issue collateral. But what they're offering is either shares in closely held companies or future cash flow from specific real estate projects under development.

Shares in other companies, S&P points out, would be difficult to cash out on at a reasonable valuation. Future cash flow ties repayment to the success of a particular project.

Besides demanding better collateral, which they are not, investors could require higher interest on the debt they're taking, but they haven't been doing that either. Look at the spread – the difference in interest between corporate bonds and government bonds of similar terms. Blue-chip bonds are trading at a spread of just 90 basis points – very little – above sovereign government bonds, just as government bonds are trading at record low rates.

Mind you, this is not quite the free-for-all characterizing the go-go years of the corporate bond market before the great global crash of 2008. With a few exceptions like The Israel Corporation, the big holding companies can no longer issue debt and institutions are looking carefully at balance sheets and cash flow statements. (In fact, they have no choice since the Hodek reforms went into force just over two years ago.)

Who could resist?

The reawakening of the corporate bond market seems to be the meeting of two reckless minds.

For sellers of debt, the rush back into the bond market is obvious. Bank credit is hard to get, especially for real estate companies, which accounted for about half of all new issues in February, and the bond market is a ready and willing lender. Bond prices have been rising and rates are low. Even for issuers who won’t need the cash, the opportunity is too tempting.

For the buyers, the calculations are more complicated, but they seem to come down to a surfeit of cash and no better place to put it. The mutual funds at the end of February had a record NIS 184 billion under management, with a net NIS 4.3 billion added in the last month from new money. Of that, NIS 1.6 billion went into corporate bond funds and another NIS 1.3 billion into general bond funds. Interest on the better corporate bonds is so low that the funds are trying to eke out decent returns by investing more in riskier, higher-yielding debt.

Current trends hardly portend the big blowout that occurred four years ago. Not nearly as much money is at stake and the risks are smaller – but how much smaller no one can really say.

Underwriters and fund managers say they understand the risk-reward ratios. But they always say that, and they probably believe it, too.

Meanwhile, the economy in Israel is slowing, and the global economy, particularly Europe, remains a danger zone. The local real estate market is enjoying a price run-up amid a chronic undersupply of housing, but it is also subject to nonmarket forces that can easily blow up in its face.

The lesson from this (so-far) mini-boom in bonds is that the markets aren’t so good at pricing risk. There are too many contradictory signals, limits to market knowledge and a host of other factors that get in the way when supply and demand for capital intersect.

The good news: The tycoons can't borrow anymore

The fact that the holding companies have been unable to join the latest bond party, however, is good news in that it brings the tycoon era ever closer to an end.

Their holding companies are awash in debt. Until 2007, their leverage typically ranged between 30% and 40% of equity, and today it has risen to between 60% and 90%, with some exceeding that. They certainly can't borrow more and can’t even roll over what they have. That leaves them no choice but to dismantle their empires to repay.

Yossi Maiman has given up control of Ampal Israel American Corp. to his creditors, who are now trying to sell off the parts that are worth anything. Dankner’s debt woes have forced him to divest IDB group companies, and bondholders are openly talking about wresting control of the group through IDB Holding Corp. Zisser last week agreed to turn over 86% of his Elbit Imaging to bondholders while Bank Hapoalim is suing for a receiver to be named to take control of nearly half that company owned by Zisser’s Europe-Israel.

It’s not by any means assured that bondholders will come out ahead from all this, but the economy will.

Michal Fattal
Ilan Assayag