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Published on 8/22/2005 in the Prospect News High Yield Daily.

Northwest short bonds better even as strike continues; Delphi gives back some gains

By Paul Deckelman and Paul A. Harris

New York, Aug. 22 - Northwest Airlines Corp.'s bonds were unchanged to higher on Monday - the first full business day in which the Eagan, Minn.-based Number-Four U.S. airline carrier was operating with its mechanics and some other employees on strike. Traders said that the company's short bonds - the 8 7/8% notes due 2006 - were several points higher on the day, although its longer issues were pretty much unchanged.

Even the bonds of beleaguered Delta Air Lines Inc. - which on Friday warned its pilots' union that the company's cash-position had eroded beyond agreed-upon levels, a possible harbinger of new company giveback demands on the captains - were seen better on the session, getting some lift from Northwest's strength in the face of the strike.

On the downside, Delphi Corp. bonds were seen a little lower, coming off the highs they hit Friday after Lehman Brothers expressed bullish sentiments about the troubled Troy, Mich.-based automotive electronics manufacturer's chances for getting its unions and former corporate parent General Motors Corp. to help Delphi cut its costs.

Primary market activity remained virtually non-existent, just as it had been on Friday.

Secondary action was not much better. A trader lamented that "short and sweet - nothing happened. It was one of the slowest days of the year, if not the slowest. We did nothing. I wish it had been active. We sat here and tried to make things happen - but nothing happened." He chalked it up to "the dog days of summer. This week and next week is not going to be fun."

While he saw from a distance that Northwest was stronger, "we really weren't involved."

"Today was a non-event."

Northwest's 8 7/8% notes were seen by a trader at another shop "up a little." He quoted those bonds at 65 bid, 67 offered, up from 63 bid, 65 offered late Friday.

"Northwest did do a little better, especially the shorter stuff," he said. But as for the longer-dated bonds, he saw no movements in its 9 7/8% notes due 2007, which stayed at 54 bid, 56 offered, or in the 10% notes due 2009, unchanged at 47 bid, 49 offered. He did see a one-point gain to 47 bid, 48 offered in the 7 7/8% notes due 2008. All of this occurred, he said, "on very light volume."

Another trader saw the 8 7/8s as good as 66 bid, 67 offered, which he pegged as "up four or five points" from the levels seen Friday, before the walkout.

"The intermediate bonds were not up as much as the short ones," he said. He estimated the 9 7/8s up a point at 53 bid, 54 offered, and declared that "the rest of the curve" was also only up a point.

A market source saw the 7 7/8s up a point on the day at 46.5 bid.

Northwest's Nasdaq-traded shares rose 28 cents (5.20%) to $5.66. Volume of 10.8 million shares was more than double the usual activity level.

Northwest's approximately 4,400 mechanics, aircraft cleaners and facilities custodians represented by the Aircraft Mechanics Fraternal Association - about 11% of its roughly 40,000 employees - walked off the job at 12:01 a.m. ET on Saturday after several months of fruitless negotiations with the airline over its demand for $176 million in permanent annual labor cost savings, part of $1.1 billion it seeks from all of its employee groups to avoid crash-landing in the bankruptcy courts as some of its rivals - United Airlines, US Airways Group and low-cost carrier ATA Airlines - have already done.

Those talks went right down to the wire, continuing into Friday, before the two sides broke off the negotiations - Northwest claiming that the last offer from the union only offered up about $100 million of cost savings, far less than the carrier says it needs, and the union miffed because Northwest refused to budge from its plan calling for massive layoffs.

Under the expired contract, the mechanics averaged about $70,000 a year in pay, and the cleaners and custodians around $40,000. The company wants to cut their wages by about 25% and lay off about 2,000 of the union's members, or almost half of them - this on top of job cuts enacted since 2001, when Northwest had twice as many AMFA-represented workers. Northwest said that its proposed further cuts would be concentrated among the cleaners and custodians, arguing that other airlines use contractors to do that work for less money.

Northwest, in demanding the $1.1 billion of labor cost concessions from its employees, including the $176 million from AMFA, claims to now have the highest labor costs among the old-line "legacy carriers" that include rivals Delta, American Airlines, United Airlines, Continental Airlines and US Airways. United and US Air, both currently bankrupt, have cut their labor costs and pension obligations sharply under their respective Chapter 11 reorganizations, and American, Continental and Delta have cut costs considerably without having to resort to bankruptcy, although Delta, the most financially threatened of those three, is seen by the financial markets as the most likely candidate to go bankrupt anyway.

So far, of the $1.1 billion of concessions it says it must have to stay out of bankruptcy, Northwest has only gotten about $300 million, the value of a 15% pay cut agreed to by its pilots union, combined with cuts for salaried employees. The airline is negotiating with ground workers and flight attendants, and it has said it can reopen talks with pilots once it gets concessions from the other groups.

Northwest is continuing to fly, under an elaborate contingency plan that the airline spent more than a year drawing up, at a reported cost in the tens of millions of dollars. It's counting on a combination of outsourcing its heavy maintenance work - the intensive, stem-to-stern safety checks mandated by the Federal Aviation Administration, and other major operations - to off-site third-party contractors, a system already used by some of Northwest's rivals, while using maintenance supervisory personnel and replacement mechanics for the more routine on-site jobs that the airline normally does on its planes right at the airports where it operates.

"The mechanics are not on the plane" the way the pilots and the flight attendants are, said airline analyst Roger King of Credit Sights, "so no one particular flight will not take off if there are no mechanics."

Since other airlines are already outsourcing the heavy maintenance work - he named United and US Air, which went to that system once they got into bankruptcy and could get out from under burdensome contracts - and Alaska Airlines as well, "these other airlines have already lowered the bar. It's not like [Northwest] is asking anything from their mechanics that these other airlines have done so.

AMFA - a breakaway union which recruited many mechanics formerly represented by another labor group, the International Association of Machinists - has vowed to accept no job cuts but King says the reality is that "the world has changed. There's been a destructive [to airline revenues] technology - internet [ticket] pricing, and the low-cost carriers, have changed the business," King says, and all of this has made the kind of jobs-for-life system that used to prevail at Northwest and the other traditional carriers as obsolete as propeller-driven airliners.

King believes - and Wall Street would seem to agree - that Northwest's management is likely to prevail in its struggle with AMFA.

One factor is the refusal of the airlines' other unions to back AMFA by refusing to cross their picket lines. "Right now, the average seniority of a Northwest employee is over 20 years. So their pension plan and their retirement benefits are a significant part of their present net value. So if these [other employees] go on strike and the airline shuts down, I can guarantee you that there will probably be a bankruptcy filing - and they'll all be bigger losers." Therefore, at least in the case of Northwest, "a strike is not an effective weapon any more. The world has changed - and the industrial labor unions are having a hard time coming to grips with that."

To lighten its load, the airline switched to its fall schedule over the weekend, so it is only running about 1,300 flights a day nationwide instead of roughly 1,600, and while a few flights were cancelled and some were delayed, most managed to get into the air pretty much on time, carrying passenger load factors in the 80% area, about the industry norm.

While the union has decried the Northwest's replacement system and has predicted that the mechanical problems will soon start piling up and grounding aircraft, King - who acknowledges that Northwest has the oldest fleet among the major carriers, with many "maintenance-intensive" DC-9s, DC-10s and 747-200s, all at least 20 to 30 years old - says that even so, Northwest will get by because "not every plane is going to break down today - it takes a while for some kind of malfunction to develop."

Assuming most of the planes were in decent shape when the strike began, "they're not going to start breaking down for a while from the fact that the new mechanics aren't 100% familiar with the operations at Northwest." While a longer strike will put the airline's makeshift maintenance operation under more pressure, King also sees a learning curve - the replacement mechanics, all of whom have already worked for other airlines for at least five to 10 years, and who have been undergoing training by Northwest at a base in Tucson, Ariz., where it parks its mothballed planes, will come to learn about the peculiarities of Northwest maintenance system and the idiosyncrasies of the particular aircraft they are servicing, enabling them to better overcome problems as time goes by.

On top of that, he predicts that sooner or later, some AMFA mechanics will jump ship, and go back to work. "Those guys aren't going to get jobs anywhere else," he opines, "not at the same level of pay and benefits they've got now. They're not, period," and he says that it is unlikely Northwest will hire them back if the strike lasts very long - the replacement mechanics will replace them for good.

King says that even as Northwest holds the line and keeps flying during the strike, "It doesn't necessarily mean the bonds are a screaming buy - because there's still a host of issues that Northwest still has to face," including high fuel costs, heavy pension obligations, and the highly competitive airline industry, with the strong challenge the low-cost carriers are presenting to Northwest and the other legacy carriers. He cautions that "the problems that Delta is facing, now, [Northwest] is going to be facing in a year or two."

But successfully weathering the strike, he says, will show that the airline is willing to take "a tough stand," which will help Northwest when it tries to get additional cost concessions out of its other employee groups.

While there was some speculation about Northwest earlier in the summer - especially after its CEO, Douglas Steenland, warned Congress that his airline could face possible Chapter 11 absent any Washington help on the pension issue - King says that weathering the strike and then using that to get the needed cost concessions from its employee groups will give Northwest "a year or two to straighten things out."

Delta's troubles - but bonds higher

Not so for Delta, though. King says the troubled Atlanta-based Number-Three U.S. air carrier is in the process of "imploding" - besides the same issues facing the other carriers, Delta is facing a demand from its credit-card processors to set aside some $750 million - a sizable chunk of money for a company that only has about $1.5 billion of available cash. Many analysts say that's the minimum amount it has to maintain if it is to avoid being pushed into bankruptcy.

Delta faced a bankruptcy threat least fall - but managed to dodge a bullet when General Electric and American Express came to the rescue and fronted the struggling airline $1 billion. King says it is unlikely that another such deus ex machina rescue would emerge this time around.

"Delta's going into bankruptcy," he asserts. "The only way people are going to give it money is with security, and the question is - how much unencumbered collateral is left?"

The analyst allows that "it might find some miracle of escaping bankruptcy this year by somebody throwing a bunch of money in - but it's going to go next year. It's got to go some time. The balance sheet is way too big, the airline has way too much low-cost competition, so it has a top-line problem, and it's got a huge unfunded pension problem.

"So this one is not going to escape bankruptcy - it's just a matter of when."

Although bankruptcy buzz has beaten Delta's bonds down to current levels - around the mid-20s for its benchmark 7.70% notes due Dec. 15 and upper teens for the rest of its unsecured capital structure - on Monday, investors chose to ignore the warning flags, and took the longer bonds higher. A trader saw the 10% notes due 2008 at 19 bid, 20 offered, its 7.90% notes due 2009 at 18 bid, 19 offered, and its 8.30% notes due 2029 at 17 bid, 18 offered, all up a point. The 7.70s were unchanged at 26 bid, 28 offered.

Delphi dips

Apart from the airlines, traders said, there was some activity in Delphi Corp., which one trader said "gave back" some of the gains it notched on Friday.

"Most of the action was in the 6.55% notes due 2006," which he saw easing to 93 bid, 93.5 offered from prior levels around 94 bid, 94.5 offered, "a little retrenchment." He also saw the Delphi 6½% notes due 2013 half a point lower at 81 bid, 82 offered.

Maytag gains

The trader also saw Maytag Corp.'s 5% notes due 2015 at 93 bid, 94 offered, up from 91.5 bid, 92.5 offered on Friday, after Ripplewood Holdings LP said that it had decided not to increase its original $14 per share buyout offer for the Newton, Iowa-based large appliance maker, clearing the way for rival bidder Whirlpool Corp.'s $21 per share offer. Maytag formally terminated its agreement to be bought by the Ripplewood-led investor group and embraced the Whirlpool offer. Maytag will pay the Ripplewood group a $40 million breakup fee, with Whirlpool reimbursing that sum once its acquisition deal with Maytag closes.

Primary quiet

One source at a hedge fund spotted the CDX 100 index at 100.50 bid, 100.625 offered at Monday's close - unchanged in thin trading.

Meanwhile, the primary market stood stock still, producing no news whatsoever. No issues are on the road. And barring an unlikely surprise none are anticipated to price during the present week, as the junk market wends its way toward a three-day Labor Day break that will begin with an early close on Friday, Sept. 2.

Can we handle a big September calendar?

In the most recent issue of Citigroup's weekly Bond Market Roundup, that institution's high yield strategist John Fenn takes a look at the high yield asset class's liquidity picture, and focuses on the "retail" portion of the investor class.

In light of recent evidence, he contends, it is questionable whether the market it ready for a big post-Labor Day forward calendar.

"For the sixth straight week, the high-yield market experienced retail outflows (almost $200 million)," Fenn writes.

"In addition to this trend, the order of magnitude of [the most recent outflow] was fairly large. We hesitate to extrapolate any trends from the high yield issuance data for this week because it is such a seasonally slow time. However, we believe the trend in retail outflows is meaningful.

"We remain concerned by the supply and demand imbalance that could occur due to largely negative retail flows year to date, and the continued expectation for a new issuance pickup in the remainder of this year.

"We note that new domestic issuance year to date is down almost 35% from last year. Despite this sobering statistic, significant potential remains for issuance to increase its pace this year. There are several large LBO deals that we expect to occur (Neiman Marcus, Agilent Semiconductor, and maybe Toys 'R' Us) and several large potential LBOs that have a relatively high probability of occurring."

Can spreads tighten?

Fenn also traces high yield spreads back through the summer and ponders, in light of forces currently at play in the U.S. economy, which way they will likely go from here.

"Since the end of July, we have been analyzing the tightness in high yield spreads," they write. "The market recently had been as tight as 305 basis points spread to worst before it last corrected in March, and it has been encroaching on those levels again with a spread to worst of 330 basis points by the end of July."

Fenn concedes that current fundamentals are strong and default rates are extremely low - factors that customarily point to strong high yield performance.

However, he added, inflation remains a concern, long-term Treasury yields have begun to rise alongside short-term rates, which are up over 150 basis points in the last 12 months, and oil prices remain stubbornly high and may begin to put a strain on the economy.

"Some of the more uncertain events that we are watching include: (1) autos may suffer a potentially devastating bankruptcy in the short term (Delphi); (2) additional LBO activity (Agilent Semiconductor business, Kerr McGee Chemicals business, Kellogg Brown & Root, Masonite, Cablevision, Tommy Hilfiger) continues to be expected; and (3) retail flows are largely negative.

"These observations tell us that the fundamental environment is supportive to current spreads. However, we want to point out some of the potentially destabilizing events on the horizon that have largely negative biases. We believe that the market is barely compensating investors for the downside potential in these events."

Hypnotized by a flat yield curve?

Meanwhile another capital markets source told Prospect News on Monday that oil prices are beginning to impinge upon investors' so far widely held perceptions that the U.S. economy is containing inflationary pressures.

"An oil bid near $70 a barrel is getting peoples' attention," the source asserted.

"Up until now it's been pretty easy to ignore the threat of inflation because of how flat the yield curve is.

"But the rising oil price has people wondering whether or not proper inflation expectations are priced in at this point."

Until very recently, the source added, investors who are focused on higher yielding fixed-income assets have taken their cue from the Treasury market. By that measure the flat yield curve suggests that inflation is under control.

"Now with this big gorilla in the corner - i.e. oil prices - it's tough to continue to follow the 'ignorance is bliss' principle,'" the source said.


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