Outlook 2010: High-grade secondary market down from its heights, but value still to be had

By Paul Deckelman

New York, Dec. 31 - As they bid a fond farewell to 2009, high-grade investors can be forgiven if they choose to linger nostalgically over the year just past, because it certainly was a year to remember. All kinds of records were set, including records for spread-tightening, for total return and for new-deal issuance.

Of course, 2009 must be viewed against the backdrop of the year immediately preceding it - one which saw spreads on most issues wildly balloon out to junk bond-like levels in response to the cataclysm that shook financial markets in the United States and around the world in the aftermath of the Lehman Brothers Holdings Inc. collapse and the fall of the once-mighty AIG.

But even as the markets reeled in shock, the groundwork was being laid for a roaring comeback, with mechanisms put in place by the government to provide liquidity and stabilize the situation.

Just how much of a comeback came as a surprise to pretty much everyone, with year-end indices showing total returns at a very un-corporate-like 20% level, about double previous highs.

Corporate spreads tightened by an unprecedented several hundred basis points, and with the Federal Reserve keeping its key interest rates at historic lows, borrowing costs fell. That sparked a borrowing binge like none ever seen before - a record more than $1 trillion of new paper, including government-guaranteed new issues which the badly battered banks used to replenish their depleted coffers and get back onto a sounder financial footing.

Buyers mostly scooped up the new paper enthusiastically, and most issues tightened from where they had priced.

Corporate bonds, enthused one portfolio manager, "just had a fabulous year."

Pleasant as it may be to wallow in nostalgia for the year just past, it's time to move on and face the future, and market participants polled by Prospect News believe that investment grade will remain a viable and attractive place to put money in the new year, although the stellar results seen in 2009 will not be duplicated.

They see considerably more modest, though generally positive returns, with room for more spread-tightening, although the red-hot new-issue market will cool off.

However, expectations of higher interest rates toward the latter part of the year have the potential for dampening total performance, and even driving away some retail investors - a notoriously fickle group.

Who woulda thunk?

A year ago, when investment-grade denizens were reeling from the financial market bloodbath that followed Lehman's untimely demise and AIG's virtual takeover by the government - the Merrill Lynch U.S. Corporate Master Index showed a 6.8% loss on the year, considered steep by the usually sedate standards of the corporate bond world - expectations for the new year were cautiously hopeful, but the bar was set pretty low.

The actual results came as a very pleasant surprise.

"At the beginning of the year, it was expected that things would improve," a trader said, adding that he believed the market rose "a lot more than myself, as well as a lot of other people, expected it to - spreads continued to contract because there's so much money that needs to be put to work."

Matthew F. MacDonald, a managing director and portfolio manager for retail fixed income at DWS Investments, a unit of Deutsche Bank AG, called 2009 "a great year to trade bonds, in the sense that there was a lot of new issuance, there were a lot of people - investors - active in the market, in terms of people actually wanting to trade bonds. So it was an easy year to be very busy, aside from all financial crisis aspects."

MacDonald allowed that certainly, "this was not an easy year to live through, especially the first half of the year, given the economic news and the backdrop of what happened in 2008. "But in terms of the bond market, it is a year that we are unlikely to see again in terms of the amount of activity.

"Certainly we saw record primary issuance and a lot of that primary issuance came with a lot of secondary trading, as people moved bonds around and made space for new names, so we saw a lot of opportunities to build good portfolios.

"It was a good year to increase diversification and get into sectors that you don't normally see a lot of paper [in]. So that was one of the big positives of the year."

Some awesome numbers

A few days before the end of the year, the Merrill Lynch index was showing a total return of 20.97%, with MacDonald noting that "in 2000, we did 9% and 2001 we did 10%, 2002 we did 10%, then 8%. So this is like double the best prior years," although he also acknowledged that "a lot of it is coming off a really bad year."

Even so, he called the returns "pretty astonishing."

Barclays Capital, in a research report that the bank put out in early December, estimated a total return up to that point of 17.2%, with a record excess return of some 1,823 basis points.

The Markit CDX NA IG index was quoted on Dec. 29 at a spread of 84 bps, well in from its 2008 year-end level of 197.1 bps and in still further from its wide point of the year, showing the greatest weakness in the IG market, of 262 bps on March 9 - a pickup of some 178 bps.

A trader noted that a year ago, 2008 had ended with the Merrill Lynch index showing an option-adjusted spread of 656 bps over comparable Treasuries, and the 2009 year began with an OAS level of 604 bps. Fast-forward a year to the end of December 2009, with that spread nearly halved to stand in the low 300s, "so it's quite a move, absolutely phenomenal. I would never have guessed it at the beginning of the year."

The extent of the spread tightening can be further illuminated by comparing the spreads at which certain issues began the year and ended it. Among the financials, for instance, the former Merrill Lynch & Co.'s 6.4% notes due 2017 were ending 2009 trading at Treasuries plus 187 bps, well in from 345 bps over as January began.

Among non-financial credits, Verizon Communications' 6.25% notes due 2037 started the year at 315 bps over and were ending it at 145 bps over. Kraft Foods' 7% notes due 2037 opened the year at 425 bps over and closed it out at 185 bps over - and in an even more notable tightening, Home Depot's 5.4% notes due 2016 tightened more than 300 bps during the year to 180 bps over at the end of December, from 495 bps over in early January.

The Fed "almost forced corporate bond performance to do as well as it has, in the sense that they've kept Treasury yields so low, that, to grasp for yield, corporates were the place to go," a trader remarked. "That's kind of what happened and why spreads came in so much. It was a yield play, a yield pickup.

"Grasping for yield, there was a perception - whether true or not - that we're not in the disaster mode that we were in at the end of '08, and that factored into it as well - just a little more comfortable feeling about the economy in general and going for the yield and staying out of Treasuries.

"This was true for portfolio managers, mainly, who have to show returns."

At another shop, a trader said that "across the board in decent A-rated industrial paper, [there was] probably 100 to 250 bps of spread contraction throughout the year. We've seen so many credits just come in so much. I think utilities are probably 100 bps to 150 bps, or maybe 200 bps in."

How low can spreads go?

Looking to 2010, that trader continued that "it's hard for me to fathom that these things are going to come in much more. For long-term debt, 100 bps and tighter seems to be awful tight - but once again, there's a tremendous amount of cash out there, and the cash has got to go somewhere, and people have been looking for any kind of spread-related product."

He said that was why we saw investors "going down the credit curve a little bit. First it started in the high-grade industrial AA-type paper, then it worked its way down through the BBB stuff, and now, they're actually going into the high-yield market - because that's the only place left where there's some spread."

MacDonald of DWS Investments believes that there will be "some additional tightening. There's just an endless supply of stories about money waiting on the sidelines, or capital allocations to this corporate bond sector. There's plenty of stories about whether it's pension funds or other institutional capital pools having a heavier fixed-income focus, versus whatever asset class they might be in just to get greater stability of earnings from the investment.

"So the expectation is for continued spread tightening. How much is certainly the open question," MacDonald said.

MacDonald explained that "one of the things that corporate bonds have going for them is there's not a lot of other spread product to buy in size."

For instance, he suggested, investors could buy mortgage pass-through securities, which have also had a pretty good year, though not on the magnitude of corporates, but "there's some concern, certainly, how they'll do next year if the Fed chooses to stop buying [mortgage backed securities], as they have stated, or the uncertainty about if they do continue to buy, when their current authorization runs out, whether they will continue to buy in the same size. Corporates don't quite have that uncertainty about them that mortgages do.

"Agency debt is expected to be a much smaller sector, going forward, as the result of what they did with Fannie and Freddie. And then ABS and CMBS, I think the one thing most people agree on is that it will be a smaller market in 2010 than it has been since its heyday in 2005, '06 and '07. So if you're a fixed-income investor, you just don't have as many choices."

At SCM Advisors LLC in San Francisco, the chief investment officer, Bob Bishop, "absolutely" believes that high-grade will see further spread tightening. "We're still in the high 100s in spread on the Barclays Index and we can easily see another 50 bps of spread tightening on the index, primarily driven by financials and some cyclicals. In any other year, that would be a darn good year. It won't be like last year, but that could be a couple hundred bps of excess return."

Bishop thinks in terms of excess returns - i.e., the difference between a security's return and that of a risk-free benchmark, like Treasuries - "because with Treasuries, who knows? You probably will see Treasury rates going up in the course of the year, so I would say in terms of excess return on the investment-grade side, 200 to 300 bps over the course of the year. Add whatever you think happens to Treasuries to that; that will give you the total return. If all you got was a 3.5% yield on the 10-year note, you'd get about 5.5% or 6% return on the year."

A trader projected that 2009 "is going to be a tough act to follow, certainly. I can't see us getting a double-digit return again, though we still may get positive pickup for the year.

"I think a single-digit percentage return is possible. This buying frenzy in corporates has been going on for months now, and my guess is there will be a little more grasping going out, to the longer maturities and that will keep spreads intact. If I had to make a guess, I'd say 5% or 6%, something like that - but not as much as 10%."

New deals trading tighter

One of the places where the buying frenzy was clearly evident in 2009 was in the behavior of new deals, especially for well-known "big" names, which came to market as part of investment grade's trillion-dollar pricing parade and then tightened smartly from there.

As the year was coming to a close, recent deals which were seen still actively trading around in the secondary, and at a notable premium to their initial pricing levels, included Sherwin-Williams Co.'s 3.125% notes due 2014, which were quoted at 63 bps over; the $500 million issue had priced at Treasuries plus 82 bps on Dec. 16.

Blackstone Corp.'s multi-billion-dollar Dec. 7 offering remained popular, with its $1 billion of 3.5% notes due 2014 having narrowed by about 20 bps to the 114 bps level and its $1 billion of 5% notes due 2019 having likewise come in to 140 bps over from 160 bps. Xerox Corp.'s $1 billion of 4.25% notes due 2015 did especially well, tightening by nearly 50 bps to 177 bps over Treasuries just before the New Year, from its 225 bps over pricing level of Dec. 1.

"Unless there's a catalyst out there that we don't know as yet, new deals will probably continue," a trader said - and will continue to trade up. "Even though Treasury rates are going to be higher in 2010, they're still going to be historically low, and I would imagine that with credit easing a little bit, we'll continue to see a lot of new corporates."

One of the busiest names in the high-grade secondary on many of the days since its pricing on Nov. 9 has been Cisco Systems Inc.'s $5 billion three-part mega-deal. The San Jose, Calif.-based high tech powerhouse's $2.5 billion of 4.45% notes due 2020 was quoted as tight as 81 bps in relatively busy trading during the last sessions of 2009 - when it was among the most actively traded credits - well in from 100 bps at their pricing, while its $2 billion of 5.5% bonds due 2040 had tightened to 115 bps from 130 bps at their pricing, also in active volume.

But SCM's Bishop is skeptical about the latter credits going forward, declaring "I think that stuff is done, whether it's Cisco or HP, IBM, all the really high-quality [tech] names. Those were great names a year ago. That stuff has tightened in to levels that are sort of 2007 levels."

He is equally cool toward "Big Pharma - they've tightened in to double-digit levels in the 10-year space. That's close to 2006-type levels. So the high-quality, single-A really big corporations probably don't have any upside."

However, he does picture those kind of names possibly playing a key role in the 2010 investment-grade picture anyway - as potential acquirers of smaller credits with more upside to them in the kind of merger and acquisition scenarios which most market participants anticipate will liven up 2010.

XTO deal signals more M&A

DWS' MacDonald opined that energy "should continue to do well, with oil being relatively stable in this kind of $70-$80 [per bbl] kind of range, if you're at the lower end of that. That gives energy companies a lot more certainty for planning.

Certainly ExxonMobil making the bid that they did for XTO Corp.'s natural gas assets helps support companies in that sector, when a major energy company decides hey, this is where we want to be in the future, even though natural gas, the commodity has struggled a little bit, that's very supportive of companies in that sector.

" I think what will be interesting to see play out is if some of the smaller single-play or more narrowly focused companies benefit from the bigger energy companies wanting to shore up either holes in their product offerings, or build on their strength, that's generally positive."

A trader at another shop said that "not only did XTO tighten after the deal was announced, but all the related names to XTO were tightening in, in anticipation of more of that merger and acquisition type business going on."

"I think this will spread to other sectors as well - Mergermania will start working its way around," the trader said.

Another trader agreed that "mergers and acquisitions, generally speaking, will come back more this coming year."

While the end of 2008 and the start of 2009 saw a dearth of such buyout deals, things started to pick up as the latter year wore on and should continue into 2010, "just because of the low financing costs still continuing. Even if interest rates rise, by historical standards, it's still so low, that I think a lot of these firms will take advantage of that kind of stuff, and of some of the efficiencies that have come in these kinds of [targeted] companies because of all the problems - the layoffs, retooling, restructuring their own balance sheets, that kind of thing."

What's hot, what's not

The trader further said that health care, medical and pharmaceutical-type sectors "I would think would do pretty well - but consumer cyclicals, maybe not so much, because consumers haven't come back really strong yet."

Also seen on the upside at that same shop are "many of the solid industrial companies that have refinanced some of their debt, or are going to come to market to clean up their own balance sheets and take advantage of the low-interest environment - they've laid off people already, have been though all of that, or at least, a lot of it. Hopefully everyone's working a little more efficiently now and will be able to make money again, real profits.

"So I think those kind of sectors will do OK - but not consumer products, and not bank and finance, because there are still a lot of negative underpinnings out there for the financials - they said that commercial real estate will be the next shoe to drop, consumer debt, credit card debt's going to be a big, big problem. I think the banks still have a lot of headline risk."

On the other hand, a trader whose desk trades in financials believes that "there's still some room [for further spread tightening] in financials and banks. I think you're going to see continued separation between the 'good banks' and the 'bad banks,' so to speak, whether it's on an international scale, with a Citigroup or a Bank of America, or even in the regional world." The "good banks," he said, "will continue to do OK," although their spread tightening will be nowhere near what was seen in 2009.

He likes some of the insurance names in the market, noting that "some of the stuff that's way out there, as people get more comfortable with it, whether it's Massachusetts Mutual or Pacific Life, some of this surplus issuance they did at 300 or 400 bps over - I think you'll see that come in a little bit more, as long as people maintain comfort with it."

SCM's Bishop is meantime bullish on "the large money-center banks.

"It's funny - stock guys hate them now, because clearly they're not going to be a growth story. But what they are going to be is probably better capitalized, less risky entities than they were before, and they're trading really, really cheap to the rest of the market. So we like banks, we like insurance companies, and selected money managers, people like BlackRock. We think there's real opportunity there."

IG starting to lose its luster?

Bishop said that SCM also does like "some cyclical industries - Dow Chemical, for example, and International Paper are both names that still offer some value. So I think we continue to see some good opportunities in investment grade - just not as attractive as it was last year."

He said that investment grade "is further along in its spread-tightening than high yield - obviously. It didn't have as far to go - but it's moved pretty fast anyway."

With most of the spread tightening in high grade having already been accomplished, he said that "we've actually started rotating out of some of our investment-grade names," and putting an increasing amount of money into commercial mortgage-backed securities, "as high-grade starts to lose some of its luster."

In its year-end report, Barclays Capital analyzes the three major sources of fund flows into the investment-grade market in 2009, particularly when it came to absorbing the tremendous supply of new paper - insurers, pension funds and individual retail investors, who buy in through mutual funds, and it concluded that the first will at the very least hold steady in 2010, while the second is on course to actually move more monies into corporates, particularly on the long end of the curve.

However, the third category - the mutual fund-based retail investors - could be at risk, as corporates start to lose their luster, to echo Bishop's phrase, as equities start to become more attractive.

The Barclays analysts found that much of the sharply increased retail buying of corporates in 2009 was directly related to the sharp drop in equity values in 2008, which continued through the first quarter of 2009 and which only started to reverse themselves as the year wore on.

Retail flows into investment grade stayed strong for the remainder of 2009 because corporates continued to perform well on an absolute basis and relative to other asset classes - but the analysts warned that heading into 2010, the Federal Reserve is expected to start tightening liquidity and interest rates will rise, which "could lead to much less compelling comparisons to equities" and other short-duration investments, putting retail flows at risk and creating "a potential source of technical weakness for credit, particularly in the second half of the year."

Boring is better

DWS portfolio manager MacDonald observed that after the wild roller-coaster ride which the normally relatively sedate corporate bond world has taken over the past two years - 2008's worse-than anticipated plunge, followed by 2009's sharper-than-expected rebound - "I'm hoping that we have a boring year. I think a boring year would be good to get people focused on fundamentals."

He quipped that for the financial media, such as Prospect News, such an environment would be "tougher for you guys, because it's harder to write stories, but easier for us to manage portfolios. I think really, the challenge is going to be where do you go from a very low-rate environment and how that's going to play out."

Noting the familiar proverb, generally attributed to the Chinese, "may you live in interesting times" - usually interpreted as expressing a veiled hope that the addressee suffers all manners of calamity - MacDonald opined that "I think we've had a full enough helping of [interesting times]. I wouldn't mind having boring times for a couple of cycles."

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