NEW YORK - Wed Oct 18, 2006 (Reuters) - Casino bonds may be an attractive bet now that the risk of holding them has retreated from a 17-month high in the wake of a buyout offer for Harrah's Entertainment Inc. (HET.N: Quote, Profile, Research).
Harrah's, the world's biggest gambling operator, received a $15 billion buyout offer from two private equity firms on October 2, spurring investment-grade bond investors to dump Harrah's 6.5 percent bond due 2016. The issue fell more than 10 cents to about 88 cents on the dollar, according to MarketAxess.
"They've traded off quite considerably since the LBO offer and the relative risk-reward looks attractive," said Joshua Greenwald of New York-based Scotia Capital, which has a "buy" recommendation on the bond. "We're seeing high-yield buyers step in and some forced investment-grade selling."
Greenwald said there's a "50-50" chance that Harrah's rejects an LBO offer at any price. That also may cause spreads to tighten further, although not all the way back to investment-grade levels, he said.
After the LBO announcement, the yield gap between U.S. Treasuries and gaming bonds such as Harrah's and MGM Mirage (MGM.N: Quote, Profile, Research) climbed to its widest since May 17, 2005, when they were at 293 basis points, according to Merrill Lynch & Co. data. Wider spreads suggest greater risk.
Standard & Poor's cut Harrah's ratings to junk on October 2, citing the LBO offer. Moody's Investors Service changed its outlook on Harrah's to "negative" from "stable."
Bond investors worry about buyouts because of the added debt load it places on company balance sheets. Harrah's said it received a $15 billion offer from private equity firms Texas Pacific Group (TPG.UL: Quote, Profile, Research) and Apollo Management. That bid has since been raised to more than $15.5 billion, according to sources familiar with the deal.
Apollo was founded in 1990 by Leon Black, a former banker at Drexel Burnham Lambert, which was the top underwriter of junk bonds before the firm collapsed that same year.
The risks of holding gaming bonds have climbed all year on concerns about increased borrowing grew as casinos planned construction projects in Spain, Slovenia, Macau and other locations, according to Adam Cohen, an analyst at CreditSights in New York.
MGM Mirage is adding to its debt to build a $7 billion CityCenter project including residential space, casinos and luxury hotels in Las Vegas.
MGM this month amended its $7 billion loan agreement, reallocating $1 billion from an existing revolving credit facility and increasing the maximum borrowing capacity to $8 billion.
The amended senior credit facilities will consist of a $4.5 billion senior revolving credit facility and a $2.5 billion senior term loan facility, extending the maturity date to October 2011.
"Before we had high capital-expenditure program and share-buyback risk, and now you can add LBO risk to that pile as well," Cohen said. "Very few scenarios look favorable for bondholders."
RALLY?
Merrill Lynch's index of high-yield casino bonds reached 282 basis points on October 4, the highest since May 2005. Spreads have narrowed since then to about 257 basis points. A similar trend happened with bonds of General Motors Corp. (GM.N: Quote, Profile, Research) and Ford Motor Co. (F.N: Quote, Profile, Research) after they were cut to junk in May 2005, according to Merrill.
Merrill Lynch forecasts that increased LBO activity and weak bondholder protection in investment-grade company bonds means the number of so-called "fallen angels" -- companies whose rating descends to junk from high-grade -- may increase. The par value of fallen angels now accounts for about 30 percent of Merrill's $645 billion high-yield index.
That may provide an opportunity for investors, according to Christopher Garman, a high-yield strategist at Merrill Lynch.
"More 'fallen angel' paper is no bad thing," Garman said in an October 4 report. "Fallen angels are actually one of the bright spots."
Fallen angels credits had a monthly average excess return of 0.31 percent, outpacing the 0.03 percent return for junk bonds, Merrill data showed.
Scotia's Greenwald also speculates that Harrah's bonds may benefit because the buyout may be financed with a smaller amount of commercial mortgage-backed securities than reported by The Wall Street Journal. The paper cited a $7 billion figure. Scotia forecasts about $2.3 billion of CMBS financing, Greenwald said.
"It's a risky bet, but at these levels it looks attractive," Greenwald said. "Certainly a lot of unknowns aren't fully reflected but the risks on the positive side outweigh the negative."
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