I took an international banking course in business school, way back when. A case study of a project loan made by an international bank consortium to New Zealand made a profound impression on me as I was beginning to understand how banks work.
The loan was to enable the government to develop an offshore oilfield. Borrowings were secured by the assets of the project; repayment was required to come solely from project revenues. The key aspect of the loan, however, was that the loan principal came due at the end of year five but the first revenue from the project was expected to come only in year six.
In other words, it was obvious to anyone who read the loan documents in even a cursory fashion that the original loan could never be repaid. Not to worry, however. This was the beauty of the transaction. It guaranteed that a lucrative (for the main underwriters) refinancing/restructuring had to take place in year three or four. The borrower may–or may not–have understood. But these were the best terms it could get.
Loans like this ultimately led to the 1970s emerging markets debt crisis.
…and Toys R Us (TOYS)
…which brings me back to TOYS. According to the Wall Street Journal, TOYS is trying to refinance $1.6 billion in junk bonds that come due through between now and 2018. The company is at the leading edge of $1.3 trillion in junk debt coming due in escalating yearly amounts between now and 2020. As the WSJ points out, TOYS’ experience in getting its refinancing done over the next two months or so will give an indication of how bumpy the road will be that other junk-rated borrowers will have to travel in the near future.
Although I worked side by side with junk bond fund managers for years, I’m not an expert. Nor are many financings as cut and dried as the New Zealand one I described above. But I have learned a bit over the years about human nature and about how financial firms work. I’m convinced that a hefty chunk of the $1.3 trillion in junk where principal repayment is coming due over the net three years was issued with the expectation that refinancing would be necessary. (I’m also confident that the offering documents contained a boiler plate warning about this possibility …and that many buyers skipped over these pages, either from laziness or because they knew that was the way these transactions worked. )
Unlike the emerging markets debt crisis of a generation ago, I don’t think a potentially serious problem with junk bonds today is the same kind of threat to world economic growth that the 1970s lending crisis was. But it could be a nasty bump in the road for junk bond funds and for the private equity firms that control companies who have been big junk bond borrowers.
We’ll know more in a month or two.