Outlook 2007: After 2006's Perfect Calm, distressed debt players still wait for junk bubble to burst

By Ronda Fears

Memphis, Dec. 29 - Distressed debt players are still waiting for the pop, the burst in the bubble of the high-yield market that will reverberate into the distressed debt market.

They were waiting a year ago.

Thus, there is an air of uncertainty hovering over the distressed debt market heading into 2007.

Default rates are at record lows and there were no major explosions in the way of bankruptcies for 2006 to discuss. That could form a backdrop for a rise in defaults and bankruptcies in 2007, but as the wait has been extended from such predictions in 2006, many are hesitant to make the call.

"2006 was the perfect storm for not filing" bankruptcy, as described by Robert Grimm of JGiordano Securities Group in Stamford, Conn. The impact of declining corporate bankruptcies was a product of a stronger economy, which allowed companies to buy some time with refinancings and the like because the markets were receptive.

"The only thing obvious is that early in the year we will continue to see LBO action. So, new issuance will remain strong. Then it will largely depend on the economy. If we go into a recession, all bets are off."

To some extent, the prevalence of hedge funds in the landscape of investors participating in distressed debt has put the traditional players at odds in assessing the market, as the more frequent use of derivatives has extracted a great deal of the risk in the bonds of a troubled company's capital structure.

Private equity's surge in coming to the rescue of troubled companies - most recently illustrated by the interest in bankrupt Delphi Corp. - is another huge factor in trying to calculate the values of distressed debt securities. Leveraged buyouts and mergers were escalating to unforeseen proportions at year-end 2006 with virtually no end in sight, and even bankrupt Delta Air Lines Inc. was getting buyout offers.

Skyrocketing liquidity, however, has kept distressed debt valuations tight even in the face of rising participation in other market niches such as the U.S. loan market, which in the past year has lured many high-yield investors with junky returns and less risk.

Thus, pricing in the distressed market was a roller coaster ride in 2006 perhaps unprecedented.

"We're hinging on the economy," Grimm said.

"The risk premium demanded won't go up that much if the economy remains strong. We are priced for perfection in the economy. Eventually it will come down. But it's a very tough call."

2006: A year of deferrals

Buying time was a major theme in the capital markets in 2006, and many onlookers and players believe that there are serious troubles still looming.

"2006 was a year of deferrals," said Brett Wyard, co-head of Carlyle Strategic Partners, the distressed team at private equity firm The Carlyle Group.

"Default rates are at an all-time low. If you had asked people 12 to 18 months ago, they would say they expected the markets to break in 2006."

Indeed, many experts that spoke with Prospect News a year ago were anticipating a downturn in creditworthiness that would lead to an uptick in defaults and bankruptcies for 2006. But the other shoe didn't fall.

A year later, the factors that would prompt such a prediction are more difficult to grasp.

"There is nothing spectacular to point at with regard to the economy, interest rates," said Wyard.

"When and what is the catalyst? I don't know. Bringing the market into efficiency, into reality, is usually an exogenous event. Liquidity can change substantially and quickly."

2007: The waiting game

After the year of transitions in 2006 - from the War on Terror to the War in Iraq, from a Republican-led House and Senate to a Democrat-led House and Senate - 2007 means the financial markets are still waiting for something to happen to paint a clear picture of the economy, said Jon Kyle Cartwright, director of institutional investment research at BOSC, Inc., a subsidiary of BOK Financial Corp. in Little Rock, Ark.

With mild economic indicators, the decision-making process is more difficult rather than easier, as he sees it.

"The capital markets and consumers are unable to make a decision," Cartwright said.

"The inverted yield cure sends two strong messages: One, a recession is looming; Two, but there is an increasingly large call from analysts and strategists that this will be different, that there will be no crash.

"This can be very scary and confusing. It's not a pretty picture."

Economic picture blurs scene

Indeed, after the most recent core inflation data was released by the U.S. government, most economists were changing their tunes rapidly. Fears subsided somewhat, which means that what many see as an inevitable retraction in the credit markets could be a protracted process.

"In lightning quick fashion, hard landing risks have faded considerably," said Moody's Investors Service chief economist John Lonski in the wake of the CPI report in mid-December.

"The recent combination of livelier-than-anticipated retail sales, a firmer labor market and unexpectedly slow core inflation very much enhances the outlook for 2007. Nonetheless, it's problematic as to whether or not inflation risks will remain well contained if the labor market tightens appreciably later in 2007."

The annualized quarterly change of ECRI's leading index of U.S. economic activity has undergone a radical transformation - from the 4.2% contraction of the 13 weeks ended Sept. 15 to the 4.0% expansion of the 13 weeks ended Dec. 8.

Thus, on Dec. 27, Lonski said in a report, "Instead of slowing as previously predicted, the annualized quarterly increase of real GDP should rise from third quarter 2006's +2.0% to +2.2% in fourth quarter 2006." And, he added, that the recent upturn in consumer spending should extend into 2008 and such forward looking indicators now signal a soft landing.

Delphi shifts playing field

Who will be participating in the distressed market is not clear, either. The field of players is not only changing, but the methods for restructurings and the structures of deals are changing as well. Private equity and its massive influx of liquidity in 2006 have largely accounted for the shifts under way, and that has had an impact on how bankruptcy exit financings are put together.

"What has historically been distressed debt players are becoming more distressed equity players," said Carlyle's Wyard.

"We are shifting to equity underwriters. Our hypothesis, with regard to the second-lien market is that structures are more complicated, there is a greater role of new equity in restructuring. Given the number of players in the market, getting control of a restructuring is more difficult."

The $3.4 billion exit financing announced in December for bankrupt auto parts supplier Delphi Corp. from a consortium including Appaloosa Management LP, Cerberus Capital Management LP and Harbinger Capital Partners Master Fund I Ltd. along with Merrill Lynch & Co. and UBS Securities LLC is thought by many onlookers as a forerunner of the new approach.

"It was remarkable," said another private equity source, referring to the Delphi exit financing deal.

"It was a case of unusual suspects," given that hedge funds Harbinger and Appaloosa joined forces with private equity fund Cerberus and investment banks Merrill Lynch and UBS.

"It could be a sign of what's to come," the source continued. "It makes sense that more private equity firms will be looking at exit financings as a way to put their money to work, since they expect defaults and bankruptcy filings to pick up next year."

Yield curve bends to LBOs

Increased leveraged buyouts by private equity firms could even be a catalyst in the uptick of defaults and/or bankruptcies.

Moody's economist Lonski said a rate cut as a result of the economic data could extend and even intensify the latest leveraging craze, which, in turn, would likely boost risk. Moreover, he says the durability of narrowing high-yield bond spreads is brought into question by a decline in upgrades' share of the number of high-yield credit rating revisions to 39% for the fourth quarter through Dec. 18 from 49% for the year at the end of third quarter.

"Although the inverted Treasury yield curve says that the Fed's next move will be a rate cut, unexpectedly brisk retail sales, a firm labor market, signs of an impending trough for home sales, the latest rally in share prices, comparatively low corporate credit risk premium and still elevated base metals prices all question the need for a lower federal funds rate," Lonski said.

"Given the current state of the US economy, a Fed rate cut probably would amplify the current boom in debt-financed acquisitions, stock buybacks and special dividends. An amplification of the current wave of balance sheet leveraging may heighten macroeconomic risk longer term."

Bottoms up, some say

With the distressed debt market being priced to perfection, as many observe, and the threat of a negative economic turn looming, many players are moving up the credit curve.

"We are bottoms up investors but we think there is a potential problem out there," with high-yield and distressed bonds trading at elevated prices while many investment-grade bonds are trading below par, said buyside analyst Cartwright at BOSC.

"We are moving into higher quality paper where the future is clearer. It's the mirror image of the inverted yield curve. I think a lot of funds are afraid to go long right now."

Second half susceptible

The second half of 2007 is many onlookers' focal point.

"We do expect a market correction in the latter part of 2007. The most likely source of such a correction, besides any macro-economic downturn, would be a surprise increase in corporate defaults," said Banc of America Securities economist Raja Visweswaran.

Cash bonds are likely to underperform in the first half of the year, against CDS as investors seek to avoid the impact of a flattening yield curve, he said. This places renewed focus on CDS spread tightening, which should be helped by the demand for structured credit.

"Demand for longer-dated structures would likely push CDS curves flatter in the first half of the year," Visweswaran said. "In particular, we expect seven-year to benefit from increased investor demand, with 10-year protection likely to tighten later in the year."

Telecoms, transports at risk

Even with major domestic air carriers Delta Air Lines Inc. and Northwest Airlines Corp. in bankruptcy, analysts say there are still considerable risks in the transportation sector. General Motors Corp. has bought a lot of time and perhaps even a cure with its spin off of General Motors Acceptance Corp., but Ford Motor Co. is still very much at risk, onlookers said.

Most of the auto parts suppliers have succumbed to bankruptcy, but Remy International Inc. could still be at risk of a filing unless there is a white knight private equity fund in the wings as market chatter suggests.

Trucking firms are still a possibility for restructurings and potential bankruptcies, however, one analyst said, pointing to USA Truck Inc. In October, the Arkansas-based trucking company said that it would be exploring strategic alternatives such as recapitalization, refinancing, reorganization, share repurchases, acquisitions and dividends on the heels of getting a $21-per-share buyout offer from Liberte Technologies, which it spurned.

And Banc of America analysts have downgraded their outlook for utilities and telecoms.

There could be another wave of restructurings among industrial players, sweeping into the consumer retail sector, another analyst said. Health care issuers are moving into the distressed area, as well, and many are looking for some heavy restructuring activity in building supplies if not homebuilders themselves.

In addition, further consolidation in the airline industry seems inevitable, many say, and that will lead to some restructuring activities. Many are not altogether enthusiastic about the long-term investment in airlines, however, particularly under the circumstances of mergers.

Many distressed players from within and without the asset class also are watching Delta and Northwest in light of the amplified rumblings of consolidation in the airline industry, and participation of hedge funds in Delta's exit plan versus a buyout offer from US Airways Group, Inc.

Real estate bottom in sight

While basic materials - copper tubing, mining concerns and the like - are expected to go into a tailspin in 2007, Cartwright said construction and real estate could extend their run into the New Year but should both see a bottom in 2007.

"We are less optimistic to those industries likely to suffer from the growth in China and India, consumer appliances, basic materials such as copper tubing and steel," he said.

"As for real estate and construction, they will probably see a bottom in the first half of the year. We don't think we're at the bottom, but we expect to see a bottom in '07. We are in the camp that the Fed is done raising interest rates, so as long as rates remain stable consumers will come to the market."

He is more bullish on moving money into natural resources, particularly on a global basis leaning to natural gas and coal, then iron and nonferrous metals.

"Longer term, the economic growth in China and India are likely to be the engine that drives global growth, even as the U.S. economy has a hiccup next year," Cartwright said.

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