NYSSA Conference: Conditions seen as ‘optimal’ for junk issuance, but lower coupons new norm

By Paul Deckelman

New York, June 12 – The high-yield primary market continues to churn out new deals, aided by conditions that one industry veteran calls “optimal” for such issuance.

However, volume levels are off a little from 2013’s record pace, partly due to a shift of some borrowing into leveraged loans as well as declines in the kinds of yields junk bonds now carry versus what they were yielding just a year or two ago.

But David Lischer, the head of the U.S. leveraged finance capital markets group for Goldman Sachs & Co., told participants at the New York Society of Security Analysts’ annual high-yield bond conference on Thursday that other factors could cause new junk bond issuance to speed up again, including a pickup in merger and acquisition activity and an increase by issuers in floating-rate paper issuance and in more aggressive types of issuance such as PIK notes or holding company notes.

By way of background, Lischer pointed out that the high-yield market in the United States has grown tremendously since the dark days of the financial crisis just a few years ago, with total volume in senior secured, unsecured and subordinated bonds almost doubling in size to about $1.5 trillion by the end of last year from around $800 billion in 2009. That’s versus just a 50% increase in overall U.S. leveraged finance debt, including institutional first-lien bank debt and second-lien paper as well as the bonds, to $2.2 trillion last year from $1.4 trillion in ’09.

“So we’ve seen the bond market really take up the slack, post-credit crisis, in terms of growth in the demand for leveraged finance product relative to loans,” he declared.

One key driver in the increased bond issuance over this period was the growth in senior secured bonds, which he said was “really nothing in the 2000s” before growing exponentially to around $300 billion by the end of last year, a growth surge that he expects to continue.

Loans lower bond activity

But even as high-yield was putting up record issuance numbers, particularly in 2012 and 2013, strength in the leveraged loan market was partially beginning to “cannibalize” high yield, Lischer said, as some issuers turned to that market for second-lien borrowings that they might have otherwise done in the junk bond market, occupying the same space in their capital structures.

Even when loan yields started to rise earlier this year – in some cases actually switching places with junk – some issuers found it was to their advantage to pay the extra premium to tap that market instead of doing a junk borrowing because the loan transactions could be more favorably structured, from their point of view. For instance, Lischer said, a loan borrower would have more flexibility to call its loan in the event of “a strategic event, a dramatic acquisition or other change” than it might have had in the junk market – no make-whole calls or other restrictive covenant provisions.

“Just pay out 102 or 101 and you’re done,” he said.

At the same time, as loans “started to cheapen up,” Lischer said, some investors reaching for yield who were able to operate in both markets found it advantageous to allocate some of their dollars to loans. For instance, he noted that when Ortho-Clinical Diagnostics Inc. tapped the debt markets for nearly $4 billion of funding earlier this spring – $2.5 billion of term loan and revolving credit debt in late April and $1.3 billion of new junk bonds in early May –in support of the leveraged buyout of the Raritan, N.J.-based health-care services company, it was one of several deals in the market around that time “where you saw the loan trade great and you saw the bonds trade poorly.”

In recent days, he said, some strength has returned to the secondary loan market, pushing yields down from the highs where they had been earlier this year.

Favorable bond conditions

While the loan market was going through those gyrations earlier in the year, Lischer said, “you didn’t see anything like that volatility in high yield.” He called the situation “a bit unusual” given the respective images that the two markets have: “Normally, you think about the high-yield market as being the volatile market and the loan market as being the stable market,” due to factors such as underlying collateral, “great” historical recovery rates and generally better covenant packages than bonds.

However, the Goldman Sachs executive said, the junk bond market was being “propped up” by robust technical factors, including what he called “a dramatic step-down” in Treasury yields – certainly an unexpected one, as those rates had been widely forecast late last year as likely to rise in 2014 “a lot and very quickly.”

Instead, the 10-year government paper started the year at the 3% mark then had plunged into the mid-2% range by February. While it has crept back up in the past few days from its lows below 2.5% to around 2.64% more recently, Lischer opined that “almost in spite of the recent sell-off in Treasuries, the high-yield market just keeps chugging along without interruption.”

Other favorable technical factors contributing to the “optimal” new-issuance conditions, he said, include the continued flow of investor money into the junk market, as evidenced by the more than $5 billion of inflows to junk mutual funds and exchange-traded funds so far this year, versus last year’s total below $2 billion, and the relative lack of market volatility, which in turn has constrained secondary market activity.

In introducing Lischer’s presentation, conference moderator Martin Fridson noted that the high-yield market “is much more focused on new issuance than [investment grade] or equities.” To that, Lischer added that for investing new capital or reinvesting existing capital after bonds mature or are redeemed, “the only place you can really look right now to put size to work is in the new-issue market. Low volatility [and] low secondary trading are optimal high-yield new-issuance conditions right now.”

There have been some hiccups along the way, but Lischer pointed out that none were serious enough to represent anything near a high-yield market closure, defined as a period of at least two consecutive months in which less than 10 high-yield bond deals have come to market during any given week. Such wrenching interruptions from the norm “have been few, and none of them have been recent,” he said, with the last such enforced market hiatus seen at the end of 2011 and the beginning of 2012, “so we’ve really had quite a nice run over the past two-plus years.”

Factors contribute to slowdown

That having been said, Lischer noted that issuance has slowed year over year. For instance, he said, $106 billion of new junk-rated paper came to market in the first quarter of 2013, and that quarterly figure declined by 24% in the intervening 12 months to $81 billion in this year’s first quarter.

One factor in the slowdown has been the lessened need for refinancing of near-term debt, which had been powering the robust issuance of the past few years.

The looming “maturity wall” of bonds and loans issued years ago coming due during the early part of this decade had been a key driver behind the red-hot issuance pace; refinancing accounted for about half of new junk issuance last year, and that shot up to 58% in this year’s first quarter. But – as several participants in other presentations and panel discussions during the all-day NYSSA conference pointed out – the artificially low interest-rate environment created by the Federal Reserve’s easy monetary policy of the past few years proved to be an irresistible lure for corporate treasurers, who took advantage of those rates in record numbers to push out their maturities, much of it by as much as seven to 10 years or even more.

Lischer said that the need to refinance debt, plus investors’ thirst for yield and their hesitancy to tap the uncertain equity markets, “led to an incredibly strong period of new issuance that has completely fixed the maturity wall,” with significant amounts of maturing bonds and loans needing to be refinanced not slated to really become a factor before 2018, when about $250 billion must be taken out.

Over the next couple of years, “you can’t really look to refinancings as a means of maintaining supply.”

“The supply picture,” he said, “needs to change, and it has to change, in my opinion, on the M&A side.”

M&A as issuance driver

Merger and acquisition activity involving high yield-rated companies, either as buyers or sellers, including LBO-generated transactions, consistently accounts for somewhere around one quarter of junk bond issuance. Lischer noted that “the good news is a meaningful pickup in M&A volumes.” However, he cautioned, “we haven’t seen any full flow-through to the high-yield market,” since an increasing portion of the consideration on such deals is being paid out in the form of equity.

He held out the prospect that “the corporate side, in our opinion, is going to be the driver on supply,” as more companies buy other companies on a strategic basis to own them and run them, as opposed to purely financial sponsorship by private equity players, with issuance by such corporate buyers “shaded towards higher quality.”

Looking elsewhere for supply

With high yield continuing to lose a certain percentage of its market share to leveraged loans and with overall junk yields down to current levels averaging below 5% – even a Caa2 LBO credit like Gates Global LLC was able to price a new deal on Thursday at what Lischer called “absolutely shocking levels” of 6% for its dollar-denominated notes and 5¾% for a euro-denominated tranche – Lischer told the analysts and portfolio managers in the conference audience that “you have to start thinking about more aggressive structures” to give investors the kind of yields they want.

One such alternative, he said, is payment-in-kind notes, which typically carry considerably higher coupons than regular cash-pay junk bonds.

He also suggested holding company debt, which he said carries coupons of at least 100 basis points to 150 bps above comparable operating company debt, indicating that the extra yield would be a trade-off balancing out any drawbacks from an investor’s point of view of holding company debt, including the company’s typically greater power to prepay such bonds.

Another area to “keep an eye on,” he said, is the issuance of floating-rate notes. He cited several deals since last fall involving floater debt issued by such high-profile junk issuers – “sizable names, guys you would know” – as AES Corp., Chesapeake Energy Corp., Avis Budget Car Rental LLC and Level 3 Communications Inc.

He said buyers of such deals have run “the full gamut of high-yield customers and also even including investment-grade buyers.”

He said that such deals, similar to loan deals, “give the issuers prepayability,” more so than traditional fixed-rate bonds.

He concluded that “this is something to watch” to see if they start to become more of a presence in the market.

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