Outlook 2009: Finally, a light at the end of the tunnel?

By Paul Deckelman

New York, Dec. 31 - "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."

So said a junk bond trader way back in late 2006, commenting on the high-yield market's unexpectedly strong performance that year, which saw spread tightening to ridiculously un-junk like levels in the 200-300 basis point range and new issuance hit record highs, fueled by a surprising surge of liquidity for M&A and LBO deals from hedge funds and other sources.

The trader, among others, warned that such explosive growth was simply not sustainable.

Now, two years later, such pessimism has been more than amply borne out, with junk coming off one its worst years ever, average spreads ballooning up to around the 2,000 bps area, the hedge funds in hiding, new issuance shriveled and high-leverage buyout deals as dead as Elvis.

Making it a great time to buy junk bonds and expect some pretty good returns. Go figure.

A year better forgotten

To say the junk market had a rough 2008 would be like saying that Warren Buffett likes to dabble a little in the stock market in his spare time. At the end of 2007 - after having seen a promising junk market rally grind to a halt in mid-summer as concern over the burgeoning subprime mortgage crisis began to sap the vitality of the financial markets - most traders and analysts surveyed by Prospect News for our 2008 outlook suggested that the junk market might post returns in the low-to-mid single-digits, with most forecasting somewhere around 4% to 5%.

Fast forward a year.

Kingman D. Penniman, the founder and president of KDP Investment Advisors Inc. in Montpelier, Vt., acknowledged that "everything we thought at the beginning of the year obviously didn't come to pass."

A bond trader at a distressed-debt shop put it another way: "We did not have any clue that things would have gotten this bad."

Indexes of junk market performance, like those put out by Merrill Lynch, that company's new corporate parent, Bank of America, and other financial firms all tell the same depressing story - a negative total return (i.e. a loss) for the year of around 30%, versus a year-earlier gain of around 1½% to 2%, and average junk spreads having widened out to nearly 2,000 basis points over comparable Treasury issues, versus around 600 bps a year ago.

According to the B of A High Yield Broad Market Index, the average dollar price for high-yield bonds had tumbled to under 70 from 93.91 on the last day of 2007, while the average yield to worst stood at 21.46% - more than twice the 9.68% seen on Dec. 31, 2007.

Another widely followed gauge of junk market performance, the Markit CDX NA HY On the Run Index, started the year at $95.11, and was closing out around $79.

Meanwhile the KDP High Yield Daily Index, which opened the year at 77.60, with a yield of 8.77%, was finishing up on Dec. 30 at 52.13, and a yield of 14.85%.

A veteran junk trader was not kidding when he said that 2008 "was a very difficult year. In my opinion, it was somewhat surprising how poorly high yield traded, given the somewhat stable default rate."

While companies seemed to be defaulting left and right during the year - whether by sliding into bankruptcy, or by failing to make scheduled interest payments or by arm-twisting their bondholders into exchanging outstanding debt for less than its par value in new debt and/or cash - by historical standards, the default rate remained at relatively low levels; Standard & Poor's said on Dec. 12 that as of the end of November, its speculative-grade 12-month trailing default-rate for United States-based issuers stood at 3.15% - up from 0.97%, a 25-year low, in 2007, but still well below its long-term 1981 to 2007 average of 4.35%.

Fundamental analysis? Forget it.

The trader opined that "the main theme of [2008] was that fundamental analysis was worthless - no matter how good a credit was, that had nothing to do with it. Basically, it was all technically driven, by money flows, which is the first time that I recollect that being the case in quite a while. Usually, everybody writes at the end of the year that 'you have to be very selective about your credits,' but guess what? - it didn't really matter," he said, with a rueful laugh. "Everything got crushed," as hedge funds and other types of bondholders had to raise cash via forced liquidations.

Another long-time trader agreed that when the junk market was in its most desperate straits, roughly in the two months following the Lehman Brothers bankruptcy in mid-September, "if there was anything that even remotely had a bid, people had to sell it - not because they wanted to sell it, but because there was nothing else to sell. So the sense of value almost went out the window."

He said that "if you had a bid, you had to hit it - nobody looked at Trace for the first time," since "very few" in the market cared about value at that point. "Execution was the key."

KDP's Penniman said that when he looks over his company's proprietary daily index of junk performance, "85% of the loss of collateral, of prices, occurred in September, October and November. We will rue the day when we allowed Lehman to file for bankruptcy, because of all of the unintended consequences that have happened" since then - which he said were still being played out as the year wound down in the financial woes of the automotive and auto-finance sectors, until Washington finally stepped in just before the year ended to bail out General Motors Corp. and to allow its 49%-owned finance arm, GMAC LLC, to become a bank and get its own bailout.

He said that the problem facing the junk market - indeed, all of the fixed-income markets - is two-fold, consisting of a credit crisis, which he defined as the liquidity problems of the big banks, sparked by the fallout from the continuing subprime debacle and the financial institutions' increasing inability to securitize toxic paper, which then produced a credit crunch, or the drying-up of funding for corporations and individuals alike.

"We had really thought that come March, with [the demise of the troubled] Bear Stearns, that the credit crisis was going to resolve itself and then we were going to turn our attention to the credit crunch. Little did we know that the credit crunch would come before the credit crisis was resolved, and I think that speaks volumes for what happened across various different asset structures this year.

"We still don't know if we have the answer - we know we have the credit crunch, but have we resolved the credit crisis? And until we resolve the credit crisis, how do we get the economy and the [individual] credits back on a firm footing?"

Uncle Sam to the rescue?

With the already faltering credit system seizing up after Lehman was allowed to slide into bankruptcy, shaking the financial markets the way the year's previous reverses, including the fall of Bear Stearns, the collapse of IndyMac Bank and Washington Mutual, and the federal takeover of troubled mortgage giants Fannie Mae and Freddie Mac had not, junk went into a tailspin.

The B of A high yield index , which had shown but a modest 2.56% year-to-date loss for the week ended Sept. 12, the Friday before the Lehman meltdown, doubled that red ink the following week, and continued to fall steadily after that, bottoming out with a yawning 32.76% cumulative deficit though early December, before finally starting to modestly pull out of that extreme slump after the Federal Reserve on Dec. 16 announced an unexpectedly large interest rate cut down to a record low level of 0.25% for its Fed Funds target and said that it would do whatever it had to do to stabilize the economy and restore liquidity to the credit markets.

"At long last," proclaimed John Lonski., the senior economist of Moody's Investors' Service's Economics Group, "the Federal Reserve may have supplied the U.S. economy with the

type of stimulatory shock that it has so badly needed since August 2007" - around the time when the subprime meltdown began to make its presence felt.

The central bank, he said, "has supplied the U.S. economy with a lot of dry timber that ought to be ignited once now-dismal expectations are surpassed. Extraordinarily low Treasury yields are likely to promote risk-taking at the slightest sign of economic stabilization."

For the high-yield market, Lonski predicted, "the Fed's forceful actions and assurances may have effectively established a multi-decade peak for the composite speculative-grade bond yield," and might drive junk spreads - which had ballooned, on average, to above 2,100 bps the week before the Fed announcement - back down to the peaks they had hit during recent recessions and accompanying junk-market slides - about 1,050 bps over, or just half the current levels, in late 2002, and around 850 bps over in January 1991.

By the time the Fed acted - the culmination of a series of previous smaller rate cuts that had provided only temporary boosts to the junk bonds and equity markets, leaving participants ultimately unconvinced to the central bank's resolve to act dramatically - Washington had already become a whirlwind of programs aimed at providing funds to grease the wheels of the stuck economy.

Injecting equity

Following a tumultuous pair of Congressional votes amid an intense White House lobbying campaign on Capitol Hill, the Treasury Department had set up its $700 billion Troubled Asset Relief Program, or TARP, and had begun doling money out to unstick the credit markets. The government's green went first to the big banks and the large regional lenders, some of which used the funds to acquire weaker banks, thus strengthening the overall banking system, and then later to non-bank financial entities like commercial funding company CIT Group Inc. and even, eventually, to GMAC, which was allowed by the Fed to convert to a commercial bank to take advantage of the program. So were the last two major investment banks, Goldman Sachs & Co. and Morgan Stanley. The Fed meanwhile set up a facility to buy commercial paper, to get that frozen market re-started.

"The government obviously had been producing liquidity since the end of last year [2007] - but that wasn't doing the trick," said Bob Bishop, the chief investment officer for SCM Advisors LLC, a San Francisco-based investment company with $3.5 billion of assets under management.

"Of the two things we thought were important, by far the most important was when the world governments [through the Fed and other central banks] actually began injecting equity capital, because equity capital in financial institutions means they can take the liquidity on their balance sheet and actually do something with it and still be within their leverage guidelines."

Bishop added that "the other thing, that fewer people are aware of, is that the most recent plans that the government has done - the commercial paper plan, the money market plan - are all unsecured, so basically, it's direct unsecured lending to corporate America and that's the one thing that has really been lacking."

SCM starts buying

Encouraged by that torrent of liquidity coming into the market and feeling that the time had come to increase his junk exposure, Bishop started buying junk-rated bonds and loans for SCM's dedicated high yield accounts in November, and added some carefully selected better-quality high yield names, such as hospital operators HCA Inc. and Community Health Systems Inc., to the company's mostly high-grade "core-plus" portfolios.

While all of this was going on, the Federal Deposit Insurance Corp. meanwhile began guaranteeing new bond issues, first for money-center and regional banks, and eventually, even for large non-banking firms considered to be quasi-financial entities, like General Electric Co.'s financial division, General Electric Capital Corp. Although all of the latter government-backed bond issues involved investment-grade issuers - GE, for instance, sports a coveted AAA rating - the cumulative effect of the plethora of programs on market psychology cut across ratings agency lines, with junk players too lifting their market out of the cruel autumn doldrums, after several false starts. The Markit CDX junk index, after touching its low point for the year, $71.60, on Nov. 21, roared back upwards to around the $80 level by year-end.

Things can still go into reverse for yet another time and again get worse, a long-time trader said, "but I think that probably an awful lot is discounted in the market and things probably will get a little bit better than people think they will."

It's his contention that the turnaround "already has begun. It's up about 7 points [on the CDX over the last week or so]. I think the forced liquidations seem to be over with, and inevitably, you have an awful lot of cash building up on the sidelines that needs to go to work at some point in time."

Shop till you drop

Nobody in the market seriously believes that the current economic downturn is over, or even that we've seen, as Winston Churchill once said, if not necessarily the beginning of the end, then at least the end of the beginning.

However, while acknowledging that the economy is still fragile and a lot can still go wrong - one or two traders raised the possibility that another shoe may drop somewhere down the line - junk market participants said that current levels of prices and yields make high yield bonds an irresistible bargain.

"There's no question," one veteran trader exulted, "that we're probably in the biggest or best buying opportunity of our lifetimes right now, as far as the high yield or distressed credit markets." He tempered that assessment a little: "obviously that's not a blanket opinion, and at times it's like finding a needle in a haystack - but there are plenty of credits that have gotten beaten up simply because being a cash-flow-positive company, there's a bid on the paper, and when accounts need liquidity, because of redemptions, those are the bonds that have gotten beaten up, as well as the less-quality type credit."

One such credit has been Community Health Systems' 8 7/8% notes due 2015, which are sometimes regarded by some players as a sort of proxy for the overall junk market because of its large size - over $3 billion - its widespread distribution and easy tradability. The Franklin, Tenn.-based hospital operator's bonds usually gain points when the market is moving up - but they also shed points rapidly during a downturn, when accounts need to sell something, anything to raise cash, and the more desirable the bond, the easier the sale.

The bonds had traded consistently above par until mid-September, when the whole junk market began to head south after the Lehman Brothers fiasco. They bounced around at lower levels after that, bottoming in the mid-70s in late November, and again in early December, before the Fed announcement. Since that time, their health has improved markedly, and they were most recently trading north of 90, with a spread between 10% and 11%, or about half that of the average junker.

A second trader also acknowledged Community Health, as well as its sector peer, HCA, noting that "there are some credits that are holding up very well," like Nashville-based HCA's 9 1/8% notes due 2014. He said they were recently trading at 89.5.

"You have a 9 1/8% coupon, trading at 89-90 cents on the dollar - are you going wrong? I don't think so. And, you're senior to equity."

'A very good value-picking year'

Apart from the odd well-performing name like Community Health or HCA though, "now everything," the trader offered, "is trading at distressed levels - 18%, 19%, 20% [yields], where the buyers are starting to come in. I think a lot of names have been driven down mercilessly and I think 2009 can be a very good value-picking year.

"I agree with a lot of the [reports in the] newspapers and I agree with Pimco [Pacific Investment Management Co.], which said that 16%, 17%, 18% on some of these bonds, AK Steel [Corp.] just to name one, is not so bad - you're probably not going to get that kind of a return on equities, you're getting a coupon while you wait and you're senior in the [capital] structure to equities."

He continued "I have distressed fund [customers] that are looking for double-Bs, with quality, names like AK."

He called the Middletown, Ohio-based maker of specialty steel products "a good company, with great cash." Its 7¾% notes due 2012 traded most recently at 78.5, for a 16% yield, although earlier in the week, they were trading above 18%. "These yields are unheard of," he said.

The only caveat he mentioned was that "you have to be selective and you have to make sure that the credits that you're buying don't necessarily have to do some refinancing in the future" - because given the current nearly non-existent state of the junk primary market, "that calendar may not be back for a while."

Another issue that he likes, - although he acknowledges that "they're in a brutal industry" - is ArvinMeritor Inc. The Troy, Mich.-based automotive components maker's 8 1/8% notes due 2015 are trading around 42, yielding 27.5%. Despite the company's exposure to the severe problems of the domestic automobile industry, he said, the credit has its good qualities. "It doesn't have any short-term maturities to take care of and they're sitting on a ton of cash. So, do you take a flier on Arvin Meritor, in the 40s? You probably do."

The first trader said that "I can't remember a year, including in the early 90s, when we've been looking at an abundance of low-dollar prices at exorbitant spreads, like we are now."

Upturn ahead

"I believe the high yield market is going to soar," he continued. After the Fed's big rate cut and its promise to take whatever steps are necessary "was when we really saw the tide turn as far as some accounts jumping in here. I think are trying to get a head start on what may be a typical first-quarter rally for high yield." He forecast a 2009 return "in the high single-digits," percentagewise.

The trader noted that "just like we were overdone at the [market] peak, approximately 18 months ago, when I believe that we were trading at the tightest spreads ever - I recall some high yield credits trading at 200 bps off, which was ridiculous - I think we've now gone full circle to be oversold. We have cash-flow-positive companies trading at over 1,000 bps off" - the traditional measure of a distressed bond - "if not more."

Not all of the companies trading at such wide levels are necessarily good companies that just got beaten down with everything else by panicky investors indiscriminately hitting any bids coming across the transom. Quite the contrary.

"Believe me - there are certainly a number of companies that deserve to be wider than that mark and that will not, or should not rebound, because they had no business coming with new deals 18 months or two years ago, not even being sure if they'll be able to make the first interest payments, structuring toggle notes and coming with covenant-lite debt. Those are the companies I believe will falter and stay at distressed levels."

That having been said, though, the trader added that "I do believe that there is an abundance of companies out there that will rebound sharply, once everyone has the confidence in the overall market that the worst is behind us, and it seems like the Fed will do whatever it takes to backstop the falling economy that we are experiencing now."

Weighing Obama's plans

With relatively cheaply priced bonds offering big yields, and an improved market psychology in the wake of moves the government has already taken to aid the economy, as well as whatever moves the incoming Obama administration may make to further limit the recessions effects - current thinking projects a massive infrastructure stimulus package, which could benefit makers of things ranging from raw metals to machinery - other junk market participants queried by Prospect News were also at least moderately bullish on Junkbondland's 2009 season.

"Going into the new year, I would view high yield as an attractive asset class for a diversified portfolio," a trader said, "given the fact that current spreads and yields of 20% [point to] a default rate in the 20% area, but based on what I see, the worst-case scenario assumed is in a 10% or 11% area. So there should be some spread contraction, which should help the market a little bit."

"The junk market went down a lot this year," another trader said, "and probably is going to go up a lot next year [2009]".

KDP's Penniman said that "the question is not if people are going to be putting money into the market in high yield - it's when."

He said that there are "two schools of thought on this. There could be a rally - we don't talk about 'January Effect' any more - some feel there could be a short burst, then we'll realize that the economy really is in trouble and there really isn't any earnings visibility."

On the other hand, "if the fiscal stimulus program comes in here and people can start to see that the economy is going to start to recover in the second half of the year, I don't think that anybody is expecting a quite robust economy, but just seeing it stabilize and start to pick up [should be beneficial], because it's going to remain below trend but the current levels are going to compensate you. If you're not worried about market risk, this is a great time for long-term investors to be getting into the market, in both [loans] and high yield."

He believes that with junk bonds poised to outpace equities, "I suspect that just like in 1991, you're going to see a lot of equity participants looking at the type of returns that are available in high yield relative to where they are and where the market is still trading. It's going to be the equity market buying high yield that's going to create the floor and enable us to rally out of here."

Junk as an inflation hedge

With the Fed cutting rates to historic lows, thus weakening the dollar, and the central bank and other arms of the government dumping billions of dollars, if not at least $1 trillion, or more, into trying to fight off the recession's effects on the economy, inflation - long banished from the economy - is seen as possibly making a comeback in 2009.

Senior market strategist Jeffrey A. Rosenberg of Bank of America wrote in a recent report that while deflationary fears currently dominate, the success of liquidity-enhancing balance-sheet repair among the financial names "means an eventual and potentially dramatic shift toward fears of inflation."

Rosenberg said in the piece that "at some point potentially in 2009, increasing allocations to high yield can be thought of as an effective inflation hedge."

Default rates, he explained, "decline under a rapidly inflating environment as companies inflate their way out of debt," and meantime, "22% yields provide protection against rising inflation to a degree much greater than in high grade."

Rosenberg cautioned that any such shift to lower quality corporates in a debt portfolio "hinges on financial system repair first to speed the return of credit availability."

Such an outcome "remains too uncertain" for B of A to suggest that investors make "a down-in-quality move at this point."

Junk as a long-term strategy

For investors not afraid to buy junk bonds in the wake of the asset class' worst showing in years, or perhaps even decades, and not squeamish about hanging onto them, despite the market's ups and downs, the reward may be hefty double-digit returns, according to Ben Garber, an economist with Moody's Investors Service.

The "extreme liquidity premiums of Treasuries, and the fear and forced selling" that have been seen in the high-yield arena "have created what may prove to be an exceptional market dislocation - to the advantage of long-term investors."

The Moody's analyst, using an average junk-bond price of just 56 cents on the dollar, an absolutely astounding one-year default rate of 14.4% - which he says is an unlikely worst-case scenario, since such an elevated rate would be a modern-day record (the baseline projection is for a 10.7% rate, and the best-case scenario pegs the rate at 9.4%) - and what he calls a "poor recovery rate" of just 20 cents on the dollar for defaulted debt, declares that "double-digit returns are still a strong possibility."

Garber's model projects earnings of 18.7% annually on the debt that does not default, as well as a 10% reinvestment rate on coupon payments made to the holder and recovered principal on any bonds that do default. Even just a 5% reinvestment rate, with all other given conditions being equal, projects a 10.4% annual rate, which, he notes, is "not too shabby."

Garber said that the strategy is predicated on holding the bonds to maturity; over the course of such an investment, the aggregate default rate would be about 30% - but he said that his strategy would still provide double-digit returns in any case.

The Moody's analyst did caution that the best returns for his strategy would "absolutely" come from buying the higher end of junk spectrum, rather than the lower-grade credits far more likely to default and, under Garber's condition, yield only 20% in recovery rather than 100%.

However, he noted "even in the Ba rated stuff, we're seeing something incredible, since the spread on the Ba rated debt is higher than the total average junk bond spread ever seen before this year - 1,400 bps versus the previous spread record for total high yield of around 1,100 bps. You really do want to get into looking at the individual issues, because clearly, there are sectors and companies that have a higher propensity to default within high yield."

Garber said that junk market prices right now "are not fully reflecting credit risk - it's a market function issue that there's massive de-leveraging, shunning of speculative assets beyond what the credit risk would imply." He said that Treasury yields at or approaching zero "is not the type of return that people would want - it's just reflecting the extreme liquidity premium of government debt." This, he said, "increases the attractiveness of high yield debt as part of a portfolio strategy."

What's hot...and what's not

KDP's Penniman said "I don't know if there's any sector you don't have to worry about. It's definitely a bond-pickers' market and there will be good credits and bad credits."

He suggests taking a look at "some of your cables, healthcare, consumer staples and energy, now that energy has been hit, because of both the [lower] prices and because they were so rich before when everyone thought energy prices were high. I would be looking for those type of sectors. I would look at telecom and electric generation would be areas I would be looking at right now."

There are also opportunities, he said, "in cyclicals right now and some of the machinery names. One of the things we are looking at what kind of industries or kind of companies are likely to benefit from the administration's massive infrastructure buildout, and people and services that provide help for that. It could be [companies like] US Steel. But we're trying to focus on if this massive program is put into place, who's going to benefit by it. In other words, who's not going to be hurt by it?"

A trader said that "the homebuilding sector will get some kind of relief out of the government. There will be some level of incentives for people to go out and start buying homes again - to try and portray a picture that the worst is behind us and now is a good opportunity to start buying houses. I don't know how they'll frame that, but with rates coming down so low I'm sure it's just a matter of time before we'll start seeing banner headlines that mortgage rates are in the 4½% to 4 ¾% area, the lowest ever. That will get people moving. They've got to work on that next."

While he acknowledged that the homebuilders "are certainly not looking great at this second, if you hearken back say 15 years ago, we had a lot of bankruptcies - these guys owned a lot of land, and they were stuck. I think there's much better liquidity in the homebuilders this time around, pretty significant."

On the other hand, he warned. "I think you will see some [retail] guys go belly up. There's not a lot of places for them to get additional capital. Their covenants will be violated. I think we'll see a good number of Chapter 11s in the retail sector. There are just too many stores."

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