Outlook 2009: New deals expected to start slow, reach $35 to $55 billion for the year

By Paul A. Harris

St. Louis, Dec. 23 - If you are happy to bid adieu to the year 2008 you have plenty of company.

On Dec. 23, as this report was being prepared, the Merrill Lynch High Yield Master II Index posted a total return of negative 30.733%, its worst performance going back at least 20 years, stinking up the place much much worse than the second-worst performance in that time-frame, 2000's negative 5.12%, according to a sell-side source.

Heading into 2008, market watchers expected $90 billion to $160 billion of new issue business, although most expected a more modest year than 2007, which saw $155.8 billion.

Of course those December 2007 forecasts were overtaken by events including - but certainly not limited to - a meltdown in the financial sector which saw the bankruptcies of Bear Stearns, Lehman Brothers and Washington Mutual, and a massive government rescue operation to save some of the remaining institutions.

At the Dec. 22 close, with sources believing that the totality of 2008's primary market business was in the book, the market had seen $72.45 billion priced in 135 tranches, including bridge conversions where holders of bridge loan risk were simply rolled into bonds.

Of bonds actually placed in 2008, approximately 40% were related to the backlog of hot market LBO deals that were hammered together in late 2006 and during the first half of 2007, one high-yield syndicate official reckoned.

However against the backdrop of the mid-December collapse of BCE Inc.'s $52 billion LBO - which included $11 billion of junk bonds - sources said that high yield had turned the corner on the backlog. Although significant portions of the hung LBO debt might remain on underwriters' balance sheets that overhang does not loom near as large as it did one year ago, sources said.

Following the ultra-quiet summer of 2008 the underwriters hoped to bring bond deals structured with rates and indentures tailored to the new post-correction high-yield market.

Alas those too proved undoable in the wake of steep late-September declines in the global capital markets. Acquisition financing deals from Precision Drilling, Inc. and Ashland Inc. were boarded onto underwriters balance sheets, the bridge loans funded and bonds unplaced.

December's reopening deals

On Dec. 10, when El Paso Corp. priced a $500 million issue of 12% five-year senior notes (Ba3/BB-), it ended a 39-day deal drought, the longest dormant period in the high-yield primary market since 1991, according to one observer.

Then as the last sands of 2008 were about to drain through the hourglass there were a few glimmers of light.

Within a week of El Paso's Dec. 10 deal, Kansas City Southern Railway Co. priced a $190 million issue of 13% five-year senior unsecured notes (B2/BB-) at 88.405 to yield 16½%.

During the run-up to Christmas those two bonds, El Paso and Kansas City Southern, which were priced in the high-80s, had streaked to the mid-to-upper 90s.

And although the yields on El Paso and Kansas City Southern were astronomical (in the latter company's case more than twice the amount it had paid for bonds priced earlier in the year) investment bankers christened those trades as market-reopening events, and asserted that, like it or not, they point the way ahead into the 2009 primary market.

$35-$55 billion for 2009

Pressed for forecasts of 2009 new issue volume, sell-side sources - a couple of whom have now participated in these surveys over the course of half a decade and more - tended to reply with rueful chuckles, and were more reluctant that usual to provide numbers.

The estimates came in a notably tight range, however, with the lowest being $35 billion and the highest being $55 billion.

"Just to toss something out there I would suggest maybe $50 billion would be a pretty good year, but that might even be high," one banker replied.

"The first quarter is probably going to be much the same as the fourth quarter of 2008, where you have a deal here and there, and a couple of pockets in which people are able to access the markets.

"If investors decide they have cash to put to work, and these companies adjust to much higher rates, you might see some folks come to the market earlier in the year. But most of them will come in the second half, with maybe some in the second quarter."

Another senior syndicate source said that $40 billion to $50 billion would be pretty sizable, and overall expected 2009 issuance to be sporadic and episodic.

Europe: the wild card

Yet another senior syndicate official said that Europe is an unknown, with respect to 2009 issuance.

"There has been virtually no 2008 European issuance to date," the official recounted.

"However guys over there are saying that the European market is going to come back in 2009 - maybe not to historical levels, but we could see something.

"So the variables are Asia-Pacific and Europe.

"There is not likely to be anything out of Asia in 2009, at least in the traditional high-yield investor base.

"But we could see $5 billion to $10 billion from Europe. That, along with $35 billion to $40 billion in the U.S., would take global issuance to around $40 billion to $50 billion.

Defensive deals expected

"It would likely be predominantly new corporate issuance in sectors that are perceived to be defensive: oil and gas, health care, publishers.

"Retail is going to have difficulty.

"We're not likely to see much in the way of LBO financings. And acquisition financings that come are apt to come from higher quality credits with significant equity infusions north of 35% or 40%.

"We're not too far away from seeing 50%-plus of equity in any acquisition-related financing."

'Very dangerous' in Europe

A senior syndicate official in Europe was skeptical of his U.S.-based counterpart's estimate.

This official looks for deleveraging from the banks and hedge funds to continue into 2009, and asserts that the market is in "a very dangerous situation" where, even though defaults are going to go up, prices are tending to reflect the lack of liquidity rather than anything else.

"At some point in 2009 there will be a European high-yield," this banker said.

"Right now, however, we have mandates for triple-B issuers that we can't execute. So given that nothing but single-A deals have been done over here, and even the autos, which have come at spreads of 500-plus [bps], are paying that sort of spread, it's hard to be optimistic.

"Part of the problem is finding buyers, a problem we are also seeing in our investment-grade deals. The hedge fund bid is completely gone. The natural hands that this money would move into are distressed - hedge fund managers and asset managers who are facing withdrawals.

"We are trading every day, but at very small volumes. There are good bid-ask spreads, but the volumes are small."

European companies have traditionally been able to rely on local banks to secure financing, and to work through difficult periods such as the 2001-2002 market, the official said.

"This is a whole different environment because the banks themselves are under pressure, unable to lend as much.

"Companies that have been maintaining that they would not issue in this market under any circumstances are falling slowly by the wayside.

"Our advice to them is: 'Don't wait until a month before your next maturity, or you will have a big problem. If you have a financing need in 2009, particularly a maturing piece of debt, you better come early in the year.'

"However, as a prerequisite to the double-B market reopening, the triple-B market has to reopen.

"I think pressure will make that happen during the first quarter.

"Some of these [high-grade] issuers are just going to have to suck it up and pay."

Hitting 20% yields?

With highly-rated, on-the-run issuers such as El Paso Corp. and Kansas City Southern Railway paying phenomenal yields, 15¼% and 16½% respectively, Prospect News asked its sources how high yields could possibly go in the year ahead.

"I wouldn't be surprised to see a 20% print," one banker said.

Another senior syndicate official won't be surprised to see rates go higher than that of Kansas City Southern's 16½% notes.

"If you say that the high-yield market has been around for 30 years there has always been a natural ceiling for internal rates of return [IRRs] in the high teens," the banker reasoned.

"You will seldom see cash coupons that exceed 15%, or even, frankly, 14%.

"The capital characteristics of any company that is of the right size to be raising money in the high-yield market simply can't support cash coupons any higher than that.

"So you will probably see a capped coupon amount somewhere between 13% and 15%. Then you start looking at deferred interest or other ways to reduce the IRR. That will come in the form of an upfront discount, a PIK component or perhaps equity. And whether that equity comes in the form of a buy-in, or just an outright penny warrant, will be dictated by the quality of the underlying credit.

"At some point financing north of all-in yields of 18% to 20% ceases to be effective in the high-yield market.

"At that point you start moving to a mezzanine or a venture capital style of financing where you are really looking for equity-like returns. And you're likely to approach that market, as opposed to trying to approach the high-yield investor base which now, of course, is much more traditional - the real-money cash buyers versus the quick-money hedge funds or distressed accounts. The latter type seem to be exiting the primary market for now. And the real-money accounts are going to be looking for higher quality credits that are pricing in the low teens, rather than taking a bad bond on a 20% return.

"It's going to be a long time before that market comes back."

Defaults worsen

Even into Autumn 2008 some junk bond investors were taking comfort that despite all of the bad news in global capital markets high-yield defaults remained at historical lows.

However as autumn deepened, the outlook on defaults grew more pessimistic.

In November Moody's reported that the U.S. speculative-grade default rate increased to 3.4% from October's 3.3%. In the next 12 months, for U.S. and European speculative-grade issuers, Moody's forecast that default rates would increase to 10.7% and 12.5%, respectively.

A money manager from a mutual fund, whose portfolio includes junk bonds and stocks, expects defaults to maintain an upward trajectory throughout 2009.

Deferring to Moody's numbers, the buy-sider said: "With a slowing economy and the inability of distressed credits to refinance in the public market, companies are apt to hit a liquidity wall and have no choice but to file bankruptcy."

Meanwhile a senior high-yield capital markets official has an outlook somewhat less dire than the Moody's forecast.

This banker anticipates default rates of 5% to 6% three-quarters of the way through 2009.

"That's still low by historical standards, particularly when you look back to previous spikes in credit spreads," the official said.

"We've always seen the spike in credit spreads first. But credit spreads have gapped out for well over a year, and it's only now that default rates are beginning to come in line, and only very modestly.

"The big question is, if default rates go back to 2001-2002 levels, what does that mean in terms of credit spreads?

"Since defaulted credits fall out of the indexes, you would expect some credit compression to result from that.

"So it's possible you will see rising default rates against a backdrop of narrowing spreads."

Another senior official from a different institution's syndicate seemed to see things in a similar light.

"Rates and spreads are predicting a default rates in the 20% range," the banker said.

"If today's spreads are saying that defaults should be in the 20% plus range, whereas historical defaults - even in doomsday scenarios - don't get any higher than 15%, there is a very good argument that there will be spread tightening going forward.

"It won't happen overnight. But the there is a case for credit tightening in 2009.

"That's why credit markets, in general, are going to look more attractive than equities. It's easier to see how you can take comfort in tightening credit spreads versus trying to make money with equities, if that analysis is right."

Clouds in outlook for exchanges

With the shuttering of the primary market through much of 2008 the market saw a handful of distressed exchange deals surface. These deals involved some bonds that were trading in the secondary market at deeply distressed levels - some as low as the single digits.

Some of the exchanges sought to restructure the bond debt by swapping bondholders into longer-dated paper, sometimes with security that was higher on the capital structure than the bonds being tendered.

One element these distressed exchange deals seemed to share was an invitation to bondholders to lock in price depreciations of their bonds that ranged from "significant" to "downright drastic," even though the exchange levels that were being offered generally were improvements over current marks to market.

Observers tended to break these deals into two categories.

One category, the "coercive" deals, forced bondholders to ponder two options, either lock in steep price depreciations on paper that at least some of them bought at par, or take their chances in recovery should the company go under, with non-participating bondholders sometimes more deeply subordinated on the capital structure as a result of the exchange.

The second category, the "opportunistic" deals, attempted to capture the discounts at which the company's bonds were trading, even in situations where default was not apparently imminent.

Of the coercive deals the most conspicuous is the massive $38 billion restructuring of the bond debt of GMAC LLC and Residential Capital LLC. That deal, which was still developing as this report was being prepared, came with an over-riding goal for GMAC, which wants to raise $30 billion of regulated capital in order to qualify for bank holding company status that would give it access to the Fed discount window, and to the Troubled Asset Relief Program funds. In order to raise the capital GMAC needs 75% of its bonds to be tendered in the exchange.

The GMAC deal, subject to half a dozen revisions and extensions, has seen some novel twists, including an assertion by company and its sponsor, Cerberus Capital, that a pondered bond exchange between GMAC and ResCap might impact ResCap credit default swaps, even though, of course, neither GMAC nor ResCap are parties to those bilateral bond insurance contracts.

The opportunistic deals were represented by a pair of gaming companies, Station Casinos Inc. and Harrah's Entertainment, Inc., sources said.

Of those two the Station deal was ultimately pulled. The Harrah's deal got done, and was in fact oversubscribed, but not in the front end bonds which were a prime focus of the restructuring effort, with the company and its sponsors training their eyes on 2010 and 2011 maturities, according to sources.

Restructurings are going to be a big part of the originations side of the high-yield business in 2009, according to a senior high-yield capital markets official.

"While you are not necessarily originating new paper, it's the restructuring side so you can call it new issue business," the source said.

"The opportunistic exchanges really are not getting a lot of traction," the banker added.

"The coercive ones, which are getting traction, will ultimately end up in litigation. And whether or not there is any basis for litigation there will be an inflection point for underwriters where they will say that coercive exchanges just are not good for our business because it is very hard to be a dealer manager on something where every single deal ends up in litigation, and ultimately drives your investor base away from you.

"There was an early perception that investors would like to get some cash to get out of positions at a premium to mark-to-market.

"But that's proving not to be the case."

Technicals and fundamentals

As 2008 wound down the technical forces that kept the high-yield and bank loan markets under severe pressure during the last quarter were widely expected to prevail well into the early part of the new year, sources said.

"The hedge funds are going to continue to be heavy sellers across the board into next year," said a money manager from a high-yield mutual fund.

"That will put supply pressure on the market, but by mid-year we may be through the bulk of that."

This institutional investor looks for U.S. gross domestic product to remain negative at least into the first half of 2009, but also looks for the rates of decline to decrease, with the possibility that the fourth quarter of the year could be flat or even slightly positive.

"All the monetary chaos - with the Treasury ruling on the fly, deciding who lives and who dies, and letting Lehman fail - all of that really unsettled the financial markets," the investor said.

"So you saw real companies really pull back. And consumers pulled back.

"Housing will continue to be a drag on consumers, with prices going lower," the investor warned.

"And high debt burdens with rising unemployment are going to be big headwinds."

This buy-sider sees the change in U.S. presidential administrations, with Democrat Barack Obama taking office on Jan. 20, succeeding Republican George W. Bush, more or less as a positive.

"The new administration has a new long-term fiscal plan which is 'Spend, spend, spend,' said the money manager.

"That will help to support the economy at a time when consumers can't spend and business won't spend.

"Once you have a little more confidence that the decline in the economy is going to diminish, and the decline in housing is going to gradually diminish, there will be better confidence.

"That confidence, along with monetary easing, is going to allow spreads to narrow.

"But spread narrowing is only going to help the better companies. It's not going to help companies in the bottom tier because they are either going to run out of cash, or they have business plans that won't survive a long recession."

For 2009, high-yield will be a Tale of Two Markets, the investor predicts.

"I think top-tier high-yield is going to do very well, and will see capital appreciation next year. It will be a very attractive sector, and may even outperform equities. You'll get coupon income and some capital appreciation.

"However there will be a real 'tiering-out' between the top tier BB+ and the bottom-tier CCC distressed. Those bottom-tier names are likely to trade even cheaper. And you're likely to have random negative surprises there.

"So the top-to-bottom spread is going to be even wider. And the bottom-tier is, at best, going to be in a trading range, with negative surprises."

A high-yield mutual fund manager in the Midwest takes his cue from the above-mentioned distressed bond exchange deals and forecasts that 2009 is going to be a restructuring year.

"The people who outperform will be the ones who are not in covenant-lite deals," the buy-sider said.

As for the possibility that one or more of the Big Three U.S. auto manufacturers could file for bankruptcy in 2009, such an event might stampede the markets in general, but the high-yield market is apt to sit out that stampede, according to a senior debt capital markets banker.

"The high-yield is probably positioned to understand what is going on there, and is positioned for the worst-case scenario," the banker said.

"It has been pretty transparent for a long time.

"If they were to go bankrupt it would not be the kind of surprise we had in the fall, with the financials, which really took people by surprise. With Washington Mutual you had a situation where it just came crashing through the market: they were downgraded so quickly, and then they had a default issue.

"That's when people get whipsawed.

"The auto story has been playing out for a couple of years. People have their positions which express their view whether they think the companies are going to default or perform. They've had time to work those views into their trading strategies."

TLGP starts recovery

This banker holds with the overwhelming consensus of sources who spoke to Prospect News in the waning days of 2008: at least in the first half of the year the primary market will only be open to high-quality corporate deals from sizable blue chip names.

"I don't see it trickling down to weak single-B financings, or to anything aggressive," the banker said.

"If you take a step back, I think our market has shaped up considerably since the government put the [Temporary Liquidity Guarantee Program TLGP] in place, because the high-grade market shaped up.

"The high-grade market had a huge overhang from activity that needed to occur. And with the TLGP guarantee all of the short-term paper that needed to be refinanced came to market and was addressed."

That regeneration reduced the overhang in the high-grade market, and investors made money, the banker said.

"You had this issue of the government guarantee, but it was coming with 150 basis points to 250 bps back of Treasuries. So it was pretty easy to see how you make money in that scenario.

"Away from the TLGP financing you have the regular corporate and industrial names getting access to the high-grade market.

"Then we started to see a trickle down into the higher quality names in high-yield.

"That's typical of a recovery.

"I would expect to see that into January."

The banker pointed out that in late December a backdrop for this recovery scenario appeared to be taking shape in the high yield secondary market as well as in the CDX High Yield 11 index. In mid-to-late December prices of non-distressed bonds began improving in the secondary market, with the recently priced issues from El Paso and Kansas City Southern up nearly 7 to 9 points from their issue prices. The index, meanwhile, traded into the mid-to-high 70s after having been range-bound in the low 70s [72½ bid, 73½ offered] for weeks.

"The sentiment is the most positive I've heard for quite a while," the banker said.

2009 calendar starts empty

However much sentiment may have been improving late in the year, however, 2008 came to an end with an empty high-yield forward calendar, and little expectation that the new year will get off to anything more conspicuous than a modest start.

Because of the financial disclosure requirements of the Sarbanes-Oxley legislation, any issuance window that might open in the January primary market would do so only briefly, the banker said.

"It will be interesting, as we get into the new year, because there will only be a couple of weeks for companies to raise money as they roll into their Dec. 31 year-end, and won't be able to use their Sept. 30 numbers to issue because their auditors will require them to get their new Dec. 31 numbers done, which is a two- to three-month process," the sell-sider explained.

"So until that point people won't be able to come back to the market.

"There will be a couple of weeks in January, and then you'll have to wait at least until the middle of March for additional corporate activity."

Another senior high-yield syndicate sources expects the beginning of 2009 to look a lot like the last four months of 2008.

"Some people think 2009 will be the inverse of 2008: the first six months will be very stagnant like the last six months of 2008, but in the second half of 2009 we could return to a more normalized market," the banker said.

"By 'normalized' I mean something similar to a 2003-2004 type of market, coming off of the end of 2001-2002. Volumes will be down materially year-over-year, given that we had a couple of very strong windows toward the middle and end of the first half of 2008. So even if you see those types of levels during parts of 2009, don't expect that overall issuance will be up year-over-year."

This banker expects corporate refinancings, as opposed acquisition-related financings, to be the dominant theme of the 2009 primary market.

"There were deals in 2008 that were 'legacy deals' on a number of fronts: the more traditional legacy of the LBO-overhang, and also some acquisition-related financings that were not necessarily committed to during the good time, but certainly engaged prior to the total meltdown of the markets; with those deals you saw a renegotiation of terms.

"That fueled some of 2008 issuance.

"But in 2009 there will be a flight to quality, both in terms of credit ratings, and in terms of sector. Higher-rated issuers that are perceived to be defensive will likely be able to access the markets, albeit not as efficiently as before, but at some level.

"However," the banker warned, "right now there is no practical level for over 90% of our market."

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