High yield veteran Bob Levine says refinancing, M&A still junk drivers

By Paul Deckelman

New York, April 18 - Bob Levine has been around the block a few times and has seen the peaks and valleys in Junkbondland.

In a career that stretched from the mid-1970s, Levine had a front-row seat as the junk market as we know it evolved and grew into the trillion-dollar beast it is today. Many of the world's largest and most famous companies are now counted among its over 1,000 issuers, including such iconic blue-chip names as General Motors Co., Ford Motor Co. and United States Steel Corp., to name just three.

Levine began at JPMorgan as a young credit analyst fresh out of the Wharton School of Business and then moved first to Kidder Peabody, where he helped found that company's eventually thriving junk bond department as head of research, and later on to Nomura Securities, where he and some other Kidder alumni did the same thing in the early 1990s.

Levine saw junk bonds emerge as a major corporate financing tool, particularly through the efforts of Kidder rival Drexel Burnham Lambert, then saw the market knocked down circa 1989-90 with the fall of Drexel and its junk-bond king, Michael R. Milken. He then witnessed high yield's recovery after that, going through bull and bear cycles as the years rolled on.

Levine ran Nomura's junk bond asset management business from October 1991 through January 2010, when he retired from the day-to-day junk bond wars. During that time, Team Levine racked up a cumulative 695% return - nearly double the 364% cumulative return recorded by the widely followed Merrill Lynch high yield benchmark index during that same timeframe.

More recently, junk participants saw incredible spread-tightening in the mid-2000s that drove those spreads down to very un-junk-like average levels versus Treasuries in the 200 basis points to 300 bps neighborhood. That was followed by the 2007-2008 market meltdown, which saw those same spreads balloon out by a factor of nearly 10 times. Whipsawing around, volatile junk staged a spectacular comeback in 2009, and there has been a generally strong market since then characterized by record heavy new issuance for several successive years. Some market participants said junk at times acquired an almost giddy, "frothy" tone - deals from all kinds of issuers were clattering down the chute and being quickly snapped up by buyers looking mostly to grab yield and put their cash to work. Sometimes, it almost seemed like due diligence was being done just as an afterthought.

But of late, the pendulum looks to have swung back the other way as macroeconomic concerns - Europe's debt crisis, U.S. deficits, a still-weak economy - had the sobering effect of dampening some of the strong momentum seen in the junk market during the early weeks of the year.

Always pick a 'Strong Horse'

"I don't think there is irrational exuberance in the high-yield market right now," Levine declared, referencing former Federal Reserve chairman Alan Greenspan's celebrated characterization of the enthusiastically booming financial markets of the mid-90s. Levine is in New York this week as part of a pre-publication publicity tour for his upcoming McGraw Hill book, "How to Make Money with Junk Bonds."

In an interview with Prospect News, he said that instead, "I think people are cautiously optimistic - but I would hope they are doing their credit work," carefully scrutinizing bonds from a fundamental analysis perspective before jumping in to them.

"You are always going to find people who don't do credit work in high yield. It's been that way forever, and it will continue to be that way. But there are a lot of people that do good credit work."

In his book, Levine outlines at length what he terms his "Strong-Horse Investing Method," which calls upon investors to do their fundamental analysis before buying a credit while holding a mental picture of a horse pulling a wagon up a hill; the wagon represents a company's debt load. He defines a Strong-Horse company as one whose strength of operations can support a relatively heavy debt burden. It can improve its creditworthiness and generate excess cash flow to pay down the debt over time. But if the horse is not so strong or the debt burden is too great for its capacities, that wagon will go nowhere. Perhaps the wheels will come off - or in extreme cases, the horse even ends up at the glue factory.

Levine outlines a series of positive attributes shared by Strong-Horse companies, including being a leader in market share, being a low-cost producer, generating excess cash flow, having controllable debt levels and establishing a history of paying down debt, among other factors. While he says all of this may seem obvious, even elementary, he points out that "it is rare that you see a junk bond issuer with all of them," so the investor has to do his or her homework and evaluate the combination of those factors to find the right Strong Horse.

A 'skittish' market

Continuing the equine analogy, he characterizes the current junk bond market as "skittish." While there are many positive factors that might inspire confidence in high yield - including a "really low" percentage of junk bonds trading at distressed levels, which translates to a likelihood of future default rates staying low, and decent quarterly earnings so far - there are also negatives that might give investors pause.

For instance, he cautioned, "Europe is a real mess. Spain has unemployment rates like the U.S. Great Depression ... so you've got to worry about what's happening in Europe."

Adding to investor skittishness about playing some of the recent bond deals, he said, is the fact that "currently, it's an issuer's market. It's not a buyer's market - and the issuers are playing games with the covenants, trying to lighten up covenants" and thus afford the bond investors less protection.

As a result, he said, "a lot of buyers are upset with that, and skittish, and they're saying 'Here we go again,' that sort of thing."

Levine said that new issuance should stay strong for quite a while, fueled by both the continuation of merger-and-acquisition activity, which often includes the issuance of new bonds to take out existing debt of the company being acquired, the acquirer or both, as well as refinancing activity not connected with any changes of control.

While a lot of the refinancing activity seen over the last several years got rid of much of the highly publicized "wall of maturities" coming due in 2013, 2014 and 2015 - largely bonds issued about a decade earlier during the great bond boom of the early 2000s - Levine said that a new driver has emerged that will spur continued refinancing.

He said that coming off the credit crunch several years ago, "when it was hard for companies to issue, they were putting on very high coupons" in order to get their deals done.

"A lot of the uses of financing this year - for a huge amount of the bonds - are to refinance now, when rates are much lower, than they were at that time. And so it's either to refinance bonds or refinance loans. You're seeing a lot of senior secured high-yield bonds at low rates refinancing bank loans as well."

However, he warned that "if the private-equity guys get too cute" in structuring the new deals for the companies they own, "I think people will walk away if they start fooling around with coupons and covenants."

10% return possible

"There are bullish people out there talking about low-teen [percentage rate] type returns. There are conservative people talking about high single-digit returns," Levine said.

Levine's own belief is that for the rest of the year, "you'll clip a coupon. If the average coupon is 8½%, you're talking about a 4½% or 5%-type coupon" return for the rest of the year.

"And then, I don't think the market is going to go down much from here. In fact, it might go up a little. So you can have a 10% type [total] return this year."

He added that "if you do, and spreads and yield levels go lower, that will feed into next year's returns. You'll have a trading range, basically."

Among areas that Levine thinks would be a good investment - with the caveat that he primarily is more comfortable analyzing individual companies rather than sectors - are hospitals, "though sometimes they put on too much debt," and energy companies.

He said of the latter companies that "prices are so high that there's a lot of money being made in excess cash flows."

Within the energy sector, some natural gas companies have struggled because prices for their commodity are way too low. However, Levine said that gas companies could be a good investment over the longer term, especially if they have a low cost of finding and developing gas reserves, "but not for a year or two."

No fan of ETFs

In looking at junk market trends, Levine questions whether the recent proliferation of exchange-traded funds is necessarily a good thing for high yield.

He said that they may be advantageous for some categories of investors, but "ETFs are not for me. I'm a credit guy, and from my perspective, I think you have to do fundamental credit research before you commit capital to high yield."

ETFs, he continued, "are good from a cost perspective, but they'll buy things that may not be suitable for the individual investor because by definition, they're designed to mimic an index."

He noted that ETFs "have taken off a lot more since I left" Nomura in early 2010 than when he was in the business. Back in the day, he said, ETFs were mostly used to short the market.

The growth of flows of investor capital into and out of those funds, he added, means that "you [almost] can't really look at mutual fund flows" to gauge overall junk market liquidity trends - "you have to look at ETF flows."

Credit analysis rules

Overall, he said, "credit analysis should always be the main determinant" of any investment, "even in a frothy market."

In a frothy market, he said, "you may not want to invest because the credit isn't good enough and something bad is going to happen, and investors are going to get hurt."

He counsels investors to "always know what you're investing in. You should always calibrate a credit and look to see whether the return is adequate for the risk."

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