Outlook 2007: Junk market rides wave of new cash to '06 gains - but pullback seen in '07

By Paul Deckelman

New York, Dec. 29 - In the movie The Right Stuff, Hollywood's homage to America's pioneering astronauts about 20 years ago, there is a scene in which the spacemen confront the rocket scientists who had been running the Mercury program up till then. Rejecting the meager role planned for them by the scientists as mere passive passengers in space vehicles controlled from the ground and seeking to enlarge their status into that of actual flying pilots in control of their own spacecraft, they threaten to use their celebrity clout as America's newest heroes to go public with their complaints about being marginalized, which could in turn jeopardize Congressional support for the program's massive appropriations.

"You know what makes your rockets go up?" one of the flyboys rhetorically demands of the bewildered scientists, and then quickly answers his own question: "Funding. No bucks - no Buck Rogers."

The high-yield bond market did not exactly soar skyward in rocket-like fashion in 2006, the way it did in 2003, when the market unexpectedly zoomed close to 30%. But this past year's return in the 11% to 12% range was certainly more than respectable, was better than virtually anyone anticipated - and like those early Mercury rockets, was fueled largely by funding, as a surge of liquidity in the second half of the year, much of it from previously largely untapped sectors, proved to be the right stuff indeed for a robust market.

Analysts, traders and others polled by Prospect News agreed that money pouring into junk bond land from private equity investors, hedge funds and other non-traditional sources, particularly to fund leveraged buyouts and other merger and acquisition transactions, both boosted primaryside issuance to record totals approaching $160 billion and pushed secondary prices on most issues up to around par, with spreads over Treasuries tightening to very un-junk-like levels of slightly more than 300 basis points, on average.

But they also said that with prices so high and spreads so tight, there's not too much room left for improvement, and mostly predicted that returns for 2007 would decline to more modest levels in the mid-single digits.

What a difference a year makes

A year ago, most analysts and other market participants were cautioning that returns for 2006 would be mediocre at best, maybe edging upward into the mid-single digits after having produced paltry gains in the 2% to 4% area in 2005.

But the reality was not so bad.

Kingman D. Penniman, president of Montpelier, Vt.-based KDP Investment Advisors Inc., noted that "while we were on the optimistic side, certainly compared with what the Street was saying last year, [the 2006 market] has surpassed everybody's expectations."

Mary Ross Gilbert, the director of fixed-income research for Imperial Capital, LLC in Beverley Hills, Calif., fully agreed that 2006's performance was something of a pleasant surprise. "There was some caution going into 2006, but it turns out to have been a good year, if you look at where issues were trading at the start of the year and where they are today. Just looking at some of the names we've been involved in, I would say the returns have been very positive.

"There have only been a few situations [that we've been involved in] that have gone sour. Most of them have done well."

But it was by no means certain from the get-go that '06 would be another strong year.

"In June, or thereabouts, we were like at a 3% return," Penniman noted, "but the market's been on a tear the second half of the year."

Among the factors he listed to explain the gain was the Federal Reserve Board finally pausing after two years of continual interest rate tightening, and even some market speculation that the central bank might at some point actually start loosening rates again.

"That all of a sudden gave an indication and a boost to the equity market - and we just saw a flood of liquidity coming into this [junk] market, looking for yield."

Liquidity worries evaporate

He said that as 2006 began, people in the market "were worried about a liquidity crunch, and that the riskier credits would be the ones that would feel the most impact - in fact, they've been the strongest sector this year."

The numbers bear him out.

In 2005, the Bank of America Securities High Yield Index, to cite one representative market gauge, ended the year with the airline-heavy transportation sector down a whopping 12.46% for the year, while its consumer durables sector, dominated by automotive-related names, closed the year with a 6.37% loss.

Fast forward to the end of 2006, with transportation up more than 11.5%, and the airlines alone (now broken out as a separate subsector following a realignment of the index earlier in the year) flying sky-high with a whopping 35% return, while the auto names - now severed from other consumer durables - were up nearly 23% on the year, and the carmakers' bonds alone up nearly 40%.

A market 'awash' in a sea of cash

"We're awash with liquidity," declared Tom Haag, high yield portfolio manager at Seneca Capital Management LLC, a San Francisco-based investment company that runs a $1.5 billion junk bond portfolio, as part of about $10 billion of fixed-income assets.

Besides what he called "traditional sources" of market cash such as pension funds and insurance companies, mutual funds and "more recently, small investors putting money into high yield over the last number of months," Haag also noted the growing importance of hedge funds, "which have become bigger players in fixed-income, and finally, and as importantly, structured products, whether its CDOs or CLOs." Of the latter, he said, "even though they might not be explicit buyers of high yield bonds per se, they are providing overall liquidity to the fixed-income markets."

With all of the aforementioned sources, "basically, net-net, the liquidity [they provide] has more than offset the large, substantial supply that we've seen this year in high yield" - a record $157.259 billion, nearly $55 billion ahead of the year-ago pace.

KDP chief Penniman agreed that "a lot of [the money coming into the junk arena] has come from non-traditional sources," because "people weren't able to get their [anticipated] returns in commodities or emerging markets at the beginning of the year."

He cited the hedge funds as the most obvious example, remarking that they were "very big players in the lower risk credits," and said "you also have private equity players - in 2007, we estimate that there's something like $150 billion to $200 billion of private equity looking for M&A and LBOs."

"There's a lot of cash sloshing around in the market," said Gilbert, "and that's contributing to the spectacular performance," particularly in formerly largely underperforming distressed areas such as the automotive sphere and the airlines.

"Whenever you have a market where there is a flow of funds that's very positive like we have now, what happens is there is so much money looking for few opportunities, and that's helping to bid up the prices overall," Gilbert said.

Mergermania!

She noted the role that the private equity companies have played in sparking the M&A and LBO boom, which has seen such familiar high-yield names as Harrah's Entertainment Inc., HCA Inc., Aramark Corp., Kinder Morgan Inc., Michael's Stores Inc. and Freescale Semiconductor Inc. recently become acquisition or buyout targets, sparking billions of dollars of new high yield issuance at a clip and in some cases, notably that of HCA, also generating market interest in companies' existing bonds.

While the conventional wisdom suggests that LBOs are bad medicine for high yield investors, since they often greatly increase the leverage of the company being acquired, Haag of Seneca Capital believes otherwise.

"While in high-grade land, the LBO scare has caused certain problems, particularly in the industrial space, [because] high-grade guys don't have covenants, high yield bonds, more often than not, have covenants" which limit management's ability to take on additional debt or to call bonds without paying an adequate premium to holders for the right to do so.

"So when there have been attempts to re-lever balance sheets within the high yield area . . . many of the high yield deals that have come this year that have been re-leveraging of existing high yield capital structures or takeouts of high yield companies by high grade credits, covenants in high yield [indentures] have oftentimes forced those entities to tender for the bonds at substantial premiums.

"So net-net, amongst all of the LBO and M&A activity, that's been a positive for high yield, because we have covenants in our bonds that prevent companies from over-leveraging - and if they do decide to do so, they have to take us out."

Delphi, Salton show way ahead

Other examples of the power of hedge fund and private equity financing to reshape the high yield market abound. In recent weeks, bankrupt auto parts maker Delphi Corp. has become the object of what's potentially shaping up to be a bidding war between an investor group led by Appaloosa Management and Cerberus Capital on the one hand, and hedge fund Highland Capital on the other.

Delphi's once deeply distressed bonds have been boosted to levels well above par for its widely quoted 6.55% notes that were to have come due in 2006 - around double the price at which they began the year.

The 12¼% notes due 2008 of struggling small-appliance maker Salton Inc. have recently been boosted to levels nearing 90 - also about double where they began the year - on the possibility that the company might be acquired by Harbinger Capital Partners and combined with sector peer Applica Inc.

"There's a lot of private equity money out there," Gilbert said, noting that Imperial had suggested such a Salton transaction earlier in the year, even before Harbinger's interest was announced, "which is why we've seen a lot of M&A activity and consolidating opportunities for some of the companies that are merging. There's plentiful capital, and it's easy to get a bank deal done to finance [a transaction]."

Hot bank debt market aids high yield

Indeed, as hot as the high yield primary has been this year, with record new issuance of $160 billion, Gilbert said that the easy availability of bank debt financing has been the real catalyst behind the recent rash of leveraged buyouts and other M&A transactions, which typically have both a bank debt and a bond component.

"I have been in high yield for 21 years, and I am just amazed to see the kind of leverage the bank deals are getting done at," Gilbert marveled. "We're in such a different environment now, where the leverage on these companies [getting financing] can be over 6.0 x and it's [considered] okay.

"If you go back five years ago, it was definitely not okay - and certainly if you go back further, it wasn't [okay then] either."

She said the easy availability for funding for restructurings of troubled credits "kind of circumvents a process that previously would have taken a lot longer." Outside some of the larger, more complicated restructurings, particularly in the automotive sector, "you're seeing pre-negotiated plans get executed and companies going in and out of bankruptcy within 90 days, and being able to negotiate for a more constructive balance sheet upon exit, so they are not so highly levered. " She said that this takes place "In some cases, [although] not in all cases."

Penniman said that besides being big buyers of high yield bonds, the hedge funds have also "clearly have been very active" in the leveraged loan market.

In fact, he said, "the leveraged loan market came in and, in effect, took a lot of the supply [i.e. demand for capital] that people were fearful would put pressure on the high yield market; instead, a lot of LBOs and M&As have used leveraged loans as their preferred [financing] vehicle, and have taken some of the supply out of the high yield market.

So instead of LBO and M&A activity "being a depressant" on high yield prices, "they've created a demand/supply imbalance which has added extra support to the secondary prices in high yield."

How long can it last?

With good technical factors such as the easily availability of cash expected to not change much in the short run, and with other signs that the planets are favorably aligned, including predictions that defaults will stay low - they now hover just under 2% on a trailing 12-months basis by most estimates and are not expected to rise much - and that the Fed will not resume its rate-tightening anytime soon, most forecasters are cautiously optimistic that junk will continue to produce positive returns in the coming year - but they acknowledge that the market is unlikely to match its 2006 achievements.

At Bank of America Securities, senior market strategist Jeffrey A. Rosenberg is of the opinion that junk will do no better than a return in the 5% to 6% range.

While he wrote in a recent report that B of A expects "an extension of the current benign credit environment well into late 2007," including moderate equity volatility and limited variability of recovery rates, in addition to the 2% default rate and little movement in high yield spreads, B of A sees a rise in risk-free (i.e. Treasury) rates, with a 40-basis point increase in the five-year governments. Such a move, he said, would trim around 200 bps from coupon returns, lowering forecasted returns to a 5% to 6% range in '07. B of A also estimates 2007 junk market new issuance of about $130 billion - about $105 billion of it in dollar-denominated bonds, and most of the remainder denominated in euros.

Morgan Stanley & Co. also sees 2007 high-yield returns in the 6% area, with the market likely to be affected by a combination of a slowing United States economy and upward pressure on interest rates. The junk market will "take a breath" after 2006's frenetic upside push, the company's analysts said, although new-deal activity will not slacken off and is likely to remain around the current $160 billion level, fueled by continuation of the wave of LBOs and merger-related transactions.

'Continuing optimism'

Seneca Capital's Haag said that his firm "generally sees reasons for continuing optimism," with economic conditions in place for continued improvement in the high yield market. He said that while the economy has been slowing, it is likely to come in for the "soft landing" that most forecasters are predicting, with only a few sectors of the economy, such as homebuilding and the automotive industry, underperforming in terms of fundamentals.

"Typically, and historically, the high yield market has done well with [GDP] growth north of 2%," Haag said. Such a modest growth rate is "a perfect scenario for high yield," since if growth goes much higher than that, "you see the Fed jump back in the game," causing fixed-income market jitters about rising interest rates.

Default rates, he said, are likely to remain at, or at least near, currently low levels. Haag pointed out that default rates are calculated on a trailing 12-month basis - meaning that in January, the rate is likely to fall, since the gigantic December 2005 default of Calpine Corp.'s nearly $20 billion of debt following the San Jose, Calif.-based power generating company's bankruptcy filing that month "will roll off," and the rate could dip as low as 1%, depending on the methodology used, a level which the portfolio manager calls "an all-time low."

Default rates are not likely to suddenly "turn north, absent some major change in the economy to the downside in the next year, which we don't see." He said that they will not push above the 3% mark till sometime in 2008, which will still be very low versus the historical average of around 4.5%.

In such an environment as he foresees, "the market tends to start to favor a little more higher quality" of issue, than in the "CCC kind of rising tide market we saw this past year - so we think that [2007] will be a little more normalized, more balanced in returns." He said that as the year progresses, "BB [credits] will start looking more competitive, versus the lower-quality." While some of the CCC names "have some juice left," it's on a credit-specific basis, rather than sector-wide.

Settling for a bit less

In terms of overall return, Haag throws his lot in with those forecasting modest returns, at least compared with 2006's, estimating "a 5% to 7% type return, which are going to still be fairly competitive in the fixed-income world - it's just not going to be as robust as it was this past year."

Haag explained that while technical and fundamental conditions are benign, and GDP "is sufficiently growing at 2% - it is [still only] 2% growth." At such a level, "you probably shouldn't have high yield spreads as tight as they are right now . . . we think spreads need to widen perhaps as much as 50 basis points or so off their lows right now."

While not seeing any "dramatic shift in the overall strength of the high yield market," he said that "we don't anticipate 2007 to be nearly as prolific in terms of returns as 2006. We don't see the math working to get us to those low double-digit 11%-plus returns."

KDP's Penniman flatly said that "I think performance [in 2007] will be less than it was [in 2006]. Depending on where you want to be in the credit strategy, the market, with spread widening, is implying that perhaps we're looking for a 6% return, with the opportunity that if you do the proper credit selection, you have the potential to pick up another 100 to 200 basis points."

What's hot - and what's not

Autos, as noted, were driving in the fast lane in terms of total returns in 2006, although Penniman pointed out that a lot of high yield funds that didn't buy into the idea that General Motors Corp. and Ford Motor Co. - struggling to cut costs, dry up oceans of red ink and boost vehicle sales - might be able to craft viable turnaround plans, stayed away from the carmakers and missed out on the big move - "85% of the funds underperformed their benchmark. Some didn't own them [the carmakers, or other troubled names] at all."

And now it's too late.

"When you look at where autos are today, and where their spreads are, there's not much juice left. So no, they will not be your best performers [in 2007]. A lot of the good news is [already] priced in."

He mentioned healthcare and some of the paper/packaging names as sectors that might perform better in 2007, depending on the economy's activity, but "I think most people are looking to shorten duration and say in the higher quality" names.

"The ability to make outsized gains is limited, because everything is [already] priced to perfection. You have a better chance of going down than up. This is why credit selection will be more important."

Merrill Lynch & Co., on the other hand, has not yet lost confidence in the auto sector - in fact, autos and gaming have the heaviest overweighting of any sectors in Merrill's year-end report. Other categories favored by the Big Bull include broadcasting, leisure, utilities and cable TV. The latter, wrote senior strategist M. Christopher Garman, is "the all-around winner, with the planets of positive Merrill Lynch credit recommendations, cheap spread-for-rating and reasonable ratings transition risks all aligned."

The Merrill Lynch analysts also like banks, diversified media, healthcare, building materials, paper and real estate, although they cautioned that these are "deep value HY wildcards" most suitable for "accounts with long time horizons and a stomach for risk."

On the other hand, Garman warned, "the all-around loser looks like food/drug retail, which trades tight for the rating, is net underweight at Merrill Lynch credit research and also has more notable downgrade potential." Other expected laggard sectors are metals/mining, hotels, consumer products and containers.

Pessimism in the trenches

Down in the trading pits, the men and women who buy and sell bonds day to day are bearish on junk's outlook in 2007.

"I think the caution flag is up," one said. "I think we're getting really sloppy on our analysis of credits, and any slowdown in the economy is going to have dire consequences - and I'm normally the eternal optimist."

He further opined that "a lot of the portfolio managers have gotten sloppy and lax [about the new credits] in order to chase returns."

"Our market is in a euphoria that will not last," another veteran trader remonstrated. "I don't feel that enough due diligence is being done, with the rash of new issues that have been coming out. I understand it, because I have seen it before, and that's why my prediction would be that we will certainly see a weakening in the high yield market. These recent new issues that have been coming tight [to price talk] will certainly be widening out. The big question is when - six months, 12 months or 18-months?"

He noted that "there's a good percentage of portfolio managers, or people running hedge funds, that were not in business in the late '80s and early '90s, to experience what many of us have experienced - that things can get pretty ugly, and they get ugly very quickly." Should oil prices shoot back up, or if the real estate bubble bursts, "and if our economy went to hell, then certainly, these bonds are going to crater."

Another market source keyed into the distressed-debt market predicted that "you're going to see a lot more bankruptcies going on - all these issues that they're doing now, I don't know how the hell they can price them - but they do."

Another old market hand flatly warned that in 2007 "we're going into a recession. Spreads are going to gap out tremendously, and the default rate is going to go up quite a lot - [though] probably not as much as it is going to in 2008, because it takes a while for that sort of thing to finally get to these companies. New issuance is probably going to dry up, and then toward the end of 2007, the beginning of 2008, the flow of funds will reverse itself, and money will start flowing back into the product as the yields make a lot more sense."

He said that the current merger boom will not last "because people won't be able to finance it. These deals that they're putting together - these companies are being held together by chewing gum. There's very little equity being put into these deals. If they work, the bondholders get paid, and the doers of the deal take out a tremendous amount of equity. If they don't work the guys [doing the deal] don't really lose much, because they don't have much invested - and the bondholders get screwed."

But not everyone in the trader community was down on the upcoming year.

One trader said he was optimistic about its prospects, although he naturally expressed a wish for more volatility. Seeing moderate economic growth and a continued low default rate, with only relatively modest junk spread widening, he asserted that "as I sit here today, I just don't see any major issues that would be negative. We also start the year without any major pockets of distressed. There's really not one sector that looks particularly bad.

He said that conditions was "a little questionable outlook for homebuilders - but I don't think anything is going to put them into Chapter 11."

He also noted all of the "money sitting on the sidelines. Any time you see some money and some action come into the fixed-income standpoint, it's generally positive, [though] from an investment-grade standpoint, it's a definite risk and a negative."

Penniman also dismisses the gloom-and-doom scenarios, observing that "there are a lot of people hoping [for a default debacle] because there are a lot of distressed funds, and a lot of lawyers looking for jobs."

Some slippage is inevitable, he said, owing to the fact that "when you see the amount of LBO and M&A activity that has taken place in the second half of 2006 and that we expect is going to continue into 2007, at some point, we'll find that some are just too highly levered or the business plan didn't work or there are going to be some problems. But at this point, the market is priced for perfection," given the low default rate and other such indicators like the Merrill Lynch Distress Ratio, currently around 1.7, "the lowest it's been since they started looking at it 16 years ago."

He added that with only 31 names out of some 1,800 in the latter measure considered to be distressed, mostly concentrated in the paper, automotive and healthcare sectors, "even if everything that's distressed defaulted, you're still looking at a low default rate."

Even so, while it seemed that the market could do no wrong in 2006, especially in the stellar second half, and in effect, investors "just threw darts at a board and whatever was the highest spread bond, they bought, and has done the best, at some point in 2007, we're going to see the fundamentalists come back in, and your better performers [among funds and other investment indicators] are going to be those who decided what not to own, rather than just buy the riskier credits."

Two-thousand-seven, Penniman said "will be the opposite of what happened 2006, it may be the year you want to be moving into higher quality." With all of the liquidity that the market now has, "if the hedge funds find that there's a new toy they'd rather play with, and aren't supporting the leveraged loans, or something else happens in another sector," it could adversely affect high yield, which Penniman noted actually happened in May and early June in 2006, when the money flow seemed to dry up and all of the major market indexes showed a choppy and uncertain pattern.

But he does dispute the assumption held in some parts that large numbers of the numerous junk bond deals done in 2003 and 2004 should start blowing up right about now, having reached the traditional window of opportunity for such credit events about three to four years after issuance.

There is a lot of paper potentially in that category. In 2003, spurred on by a red-hot secondary market, issuance more than doubled to a then-record $138 billion from the previous year's anemic $59 billion, and the following year saw even more deals getting done - well over $150 billion. Inevitably, comparisons were made at the time to the junk market's heady go-go years in the mid-90s when all kinds of new issuance went on, much of it for tech or telecom companies with sketchy business plans and apparently even sketchier due diligence by the investors - debt issues that defaulted in huge numbers when the tech bubble burst and the industry went into a shakeout around 2000.

"When you look at the [then-]record issuance we had in '04, and the large amount in '03, in those days, 75% of the issuance was refinancing," Penniman said. "So there were a lot of riskier credits that were able to lower interest rates, extend maturities and thereby improve their liquidity. It gave them time to get out of problems by selling some assets. It wasn't like this was record issuance of new names."

Now, on the other hand, "over 50% of the new issuance is in acquisition-related deals. This is the kind of new issuance that ultimately is going to cause the pressures three to four years from now."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.