By WallStreetDaily.com

Drug company Valeant Pharmaceuticals International Inc. (VRX) is teetering on the brink of default. It has $31 billion in debt, of which $13.5 billion is from the junk bond markets.

The company serves as a lesson in the dangers of short-term strategies and excessive leverage.

Both faults have been common among large issuers of U.S. corporate “junk bonds,” especially in the recent low interest rate environment. This sector’s risks thus exceed its rewards, and investors should avoid it.

A Dangerous Experiment

The Valeant saga begins with consulting company McKinsey & Company, which advises most large pharmaceutical companies on strategy.

In the mid-2000s, McKinsey noticed that the productivity of drug companies’ research and development (R&D) operations had sharply declined, with few new products gaining Federal Drug Administration approval. The industry’s portfolio of patented products had also begun shrinking as major patents began to run out.

So McKinsey began recommending that drug companies cut back on R&D, and instead concentrate on acquisitions and increasing the prices of existing drugs. Needless to say, these strategies moved drug companies from long-term contributors to the economy, to short-term fast-buck artists.

In 2008, Michael Pearson, a leading McKinsey consultant, took over a small drug company by the name of Valeant. He then proceeded to destruction test this theory.

Pearson engaged in acquisition after acquisition. In each of the acquired companies, he cut R&D spending down to the bone while raising the prices of old drugs, especially “orphan” drugs for which the company had a monopoly. (A company’s “orphan” drugs make it uneconomical for other companies to enter the market because of the costs of getting FDA approval.)

He re-domiciled the company in Canada in 2010 to avoid U.S. taxes, and paid for the acquisitions by issuing mountains of debt. A number of Wall Street’s sillier hedge funds came along for the ride, notably Bill Ackman of Pershing Square and even the Sequoia Fund, which has ties to the Oracle of Omaha, Warren Buffett.

The experiment was obviously foolish as well as immoral, and made Pearson and his backers look as dumb as bricks. U.S. drug prices are notoriously the highest in the world, far above those in most countries, which have government-imposed price controls.

The United States’ excuse for its high pharmaceutical prices is that they’re necessary to pay for research and development, which in the past led to untold benefits from new drugs and the ability to treat previously intractable illnesses, lengthen life, and improve its quality.

But if drug companies no longer pursue R&D, their high prices are no longer justified, and they’ll soon be forced to bring prices in line with international norms. Such high prices are especially unjustified on older drugs, as the original R&D was carried out many decades ago.

They’re essentially sold at high prices simply because the FDA is a witless government bureaucracy that won’t let the market admit new competitors.

Healthcare costs are a polarizing issue in the United States, especially when a new government healthcare system has been introduced by a partisan majority. The new system’s costs, and those of healthcare in general, are being closely scrutinized by politicians as well as the public.

Valeant’s strategy was bound to become politically unsustainable at some point. Needless to say, Pearson has done well for the most part – his Valeant shares were worth more than $2 billion at one point last year.

Overleveraging the entire operation with $31 billion in debt to only $6 billion in equity merely made a collapse inevitable, and spread the cost of the collapse to the junk bond market.

The Effects on the Junk Bond Market

Valeant’s $13.5 billion in junk bonds were issued to institutions under Rule 144A, so there’s no publicly quoted price, and presumably no ordinary investors as bondholders. However, the bonds will be present in many bond funds, which will deliver a nasty jolt to their holders in the event of a default.

And the company has indeed warned of a possible default at the end of March, when necessary filings go overdue.

Past years’ figures are being restated because the company instituted another wrinkle – distributor Philidor RX Services LLC was used to “persuade” Medicare to reimburse Valeant’s ultra-high drug prices. And Philidor appears to have been recording “phantom sales” that didn’t actually occur.

Valeant may avoid immediate default. But in the era of ultra-low interest rates, we’ve seen a large number of industry “roll-ups” like Valeant – many of them founded on equally dozy corporate strategies.

This period of low rates and high deal volume, as well as the lack of solid growth in the U.S. economy, has paved the way for a rocky future, one in which interest rates rise or the economy declines into recession.

The junk bond market has been the go-to destination to finance these schemes, because nobody there pays much attention to the underlying soundness of the business being financed.

Since the 1980s, junk bond investors have been trained to expect their investee companies’ strategies to be somewhat gamey. So with the market beginning to show cracks since December, it’s not a place for wise income investors to put their money, however attractive the nominal yields may appear.

Good investing,

Martin Hutchinson

P.S. For more information on how a country’s finances affect the companies headquartered there, and how you can profit from some of these situations, check out Martin Hutchinson’s Currency & Capital service. As these international companies move money, there is a massive, money-skimming operation happening inside the worldwide market for currencies. And with Currency & Capital, you don’t have to learn how to trade risky FOREX to profit.

The post Valeant Exposes Junk Bond Danger appeared first on Wall Street Daily.