Outlook 2018: Surprise – there was no HY surprise in 2017 – but 2018 seems far from certain

By Paul Deckelman

New York, Dec. 29 – In one of the so-called “Classic 39” episodes of the beloved 1950s television sitcom “The Honeymooners,” Everyman series hero Ralph Kramden is perplexed – he has discovered multiple clues that would seem to indicate that his wife, Alice, is planning a surprise birthday party for him, but when he arrives home the following evening, ready to party and to pretend to be “surprised” that everyone has gathered there in his honor, he finds, much to his shock, that there’s nobody there. His pal Ed Norton – a master of convoluted reasoning – thinks hard for a moment and then smiles as the answer to the riddle dawns on him.

“That’s the surprise,” he tells the baffled Ralph – “there ain’t gonna be no party!”

Denizens of Junkbondland have over the years come to expect the unexpected – knowing that no matter what their predictions for the coming year might be, some unexpected development always seems to pop up out of the blue to radically change the outcome. Unlike Ralph’s Party That Wasn’t – a good thing that did not take place – the junk market’s historical surprises have been mostly bad things which unexpectedly did happen.

The past several years have sometimes seen the junk market start out of the gate with a full head of steam, encounter some unforeseen circumstance midway through, such as suddenly developed market fears of an interest-rate debacle, and then just fight to stay in the black rather than drop into the red.

Sometimes, there have been actual traumatic events, usually toward the end of the year, that have surprised everyone, from the financial meltdown in the fall of 2008 to the decline in oil prices in late 2014 (with the slide continuing in 2015, dragging the market to its first loss since 2008).

Meanwhile, 2016 saw the shockingly unexpected electoral triumphs of the Brexiteers in the United Kingdom and then six months later, of Donald Trump in the United States.

In contrast, 2017 was considerably calmer, at least in terms of market-moving events, or the lack thereof. According to junk bond traders, analysts and others in the market queried toward the end of 2017 by Prospect News, the big surprise seems to have been what was expected to happen but didn’t, rather than what wasn’t expected to happen and then did.

“We didn’t have any big catastrophic crashes,” a junk bond trader observed. “The Fed has pretty much kept their hands in their pockets – the interest rate hikes that we’ve had were anticipated and priced into the market.”

Mathew Van Alstyne, co-founder and managing partner at Odeon Capital Group LLC, a New York-based independent broker-dealer and investment banking firm, opined that “the surprise is it seems like news doesn’t matter, the Fed doesn’t matter, politics don’t matter – the market went in one direction, and one direction only.

“You didn’t have any micro-crashes; you didn’t have any bubbles popping; you didn’t have any major bankruptcies that seemed to bring the rest of the market down or have a lot of impact.”

He noted that on Election Day in 2016, once it became apparent that Trump was going to score an upset victory, “for about 20 minutes, everyone thought it meant it was The End of The World for the markets – and we never even saw a hint of that throughout the entire year.”

And when the Federal Reserve raised the benchmark interest rates in March, in June and again in December, Van Alstyne said “I think you might have been able to mentally prepare yourself for bond prices going down – but that didn’t happen. So I was totally surprised on every aspect that everything was basically green or in the worst-case, kind of flat, in a year where outside of the financial world, it was essentially political chaos.”

Steven Ruggiero, the head of research at New York-based investment bank R.W. Pressprich & Co., where he also serves as a managing director, said that the junk market’s 2017 performance really came as no surprise and “was probably about what most people expected.” He noted that “defaults remained well-controlled, and the interest-rate environment was actually more sanguine than what I was thinking of and perhaps many others, in terms of the longer end.”

He said that the roughly 7%-plus total return the junk market is finishing the year with “is not all that bad,” commenting that spreads, at around 375 basis points over Treasuries, “are pretty tight.”

The tale of the tape

A look at some of the major statistical indices measuring junk market performance would seem to bear that out.

As of the market close on Dec. 14, the widely followed Merrill Lynch U.S. High Yield Master II index showed a year-to-date return of 7.277%. That was down a little bit from its peak level for the year of 7.636%, notched on Oct. 24, but was well up from its low of 0.268%, notched on Jan. 3, the first trading session of 2017 following the New Year’s holiday break. The return figure was never in the red at any time in 2017.

The yield to worst stood at 5.775% on Dec. 14. Its price figure was 100.6833 and its spread to worst was 374 bps.

While the year-to-date return was certainly respectable by historical standards, and even above what some market participants thought it might end up, it was actually well down from where it had finished in 2016, showing a 17.489% gain on Dec. 30, 2016, the last trading session of that year.

However, the other index components actually improved from the index’s 2016 year-end levels of a yield to worst at 6.168%, a price of 99.59 and a spread to worst of 439 bps.

Kingman D. Penniman, the founder, president and chief executive officer of the KDP Investment Advisors Inc. bond research and information service of Montpelier, Vt., pointed out that “it’s always been interesting that when you look at the Merrill Lynch performance and track it, after a year of negative numbers, in the first year after that, the market always reverts to the mean and has a substantial increase.”

That is precisely what happened in 2016, when the junk market was coming off its terrible performance in 2015, when it was dragged down by the low-crude-price induced carnage in the energy sector and finished with a loss of 4.63% on the last day of 2015 – its first yearly loss since 2008, the year of the great financial meltdown.

The index soared in 2016, as noted, and firmed again this year.

Penniman said that “the second year [following a downturn] is positive – this would be the second year that we have of that tremendous rebound in energy that we had in 2016.

He added that “interestingly, the third year” after a down turn, which in this case would be 2018, “is also positive,” boding well for the coming year.

Another widely followed junk bond market performance measure, the proprietary KDP High Yield Daily index compiled and issued by Penniman’s company, stood at 71.86 on Dec. 14, down from its high point earlier in the year of 72.72, but up from its low for the year of 71.24. Its yield was 5.30%.

Those levels compare favorably with the 2016 year-end index reading of 71.55 and yield of 5.41%.

In energy-problem-ravaged 2015, the index had fallen to a year-end close of 63.91 from 2014’s 70.85, while the yield had ballooned out in 2015 to 7.28% from 5.56% the year before.

Energy improvement steadies

The gyrations of crude oil prices and the impact those prices have had on companies that explore for, drill, process and market oil and petroleum products have probably been the biggest story in the junk world over the past 3½ years – since oil cascaded down from above $106 per barrel in mid 2014 into the low $50s by the end of that year and then periodically moved even lower over the next two years.

The moves made it unprofitable for energy companies to maintain normal operations. Some defaulted on their debt, and there were sector names driven into bankruptcy during this dark period.

But a strengthening of crude prices since then – as West Texas Intermediate crude improved from year-end 2015 prices in the $30s back to the lower $50s by the end of 2016 and most recently, into the upper $50s – seemed to bring some stability to the hard-hit sector.

“Oil has kind of been trading in a range,” a trader said, although he noted that even in 2017, prices dipped at several points back into the $40s, bottoming at $42.53 on June 21 before laboriously making their way back up into the higher $50s.

Those low prices “weren’t necessarily great for certain credits,” he said, but added “at the same time, a lot of these E&P companies went through their corrections a while back. A lot of them restructured, so they’re not really all that levered, or they came out as reorganized equities. A lot of these guys have cleaner balance sheets, so it’s not anything that’s really been a massive shakeup in that sector” over the past year – as opposed to previous years.

Oil, a second trader said, “has had a nice move back.”

He said that “a lot of E&P companies that, frankly, filed [for bankruptcy] over the last several years are coming out of restructuring and climbing out of the grave, as one guy put it.

“If oil is able to hold these $50-to $55 kind of levels, you’ll see a resurgence in the oil and gas market in terms of issuance,” as the energy names seek to raise capital, some of which may go into expanding their current operations by re-starting idled drilling rigs, or even help fuel merger activity within the sector, as companies seek to acquire energy reserves with an eye toward future drilling.

At another desk, a market source suggested that oil prices “are gradually working their way up. How that flows through the market in the future has yet to be seen – but it certainly seemed to take some of the pressure off” that sector in 2017.

As to whether that will continue into 2018, he said that “given where we are now, we’ll see a more stable environment for energy – not withstanding natural gas’ weakness – and we will see the credits become more stable as a result, and those that need to work through their credit issues have a better shot at that.”

Overall, he declared that “I’m positive on the energy markets, and I’m positive on energy credits, in a broader sense,” although he added the caveat that “obviously it comes down to the specifics of a credit,” with some companies perhaps still having work to do to improve their particular situation.

But as an influence in high yield, he said that energy “is not quite as topical now as it was at this time last year.”

Tax changes a wild card

One topic which was more topical as 2017 was ending was the impact that proposed changes in the federal tax code might have on the fixed-income markets generally and on the junk space in particular.

There was talk that the bill might eliminate or otherwise limit companies’ ability to deduct interest paid on bonds and loans, which most of the experts contacted by Prospect News agreed could certainly put a damper on bond issuance, forcing companies to find other financing alternatives. Early news reports when the final version of the Republican tax plan was released did not indicate that this would be a part of it.

Another potential tax law change being bandied about was the proposal to allow companies with overseas operations to repatriate cash held overseas by taxing such returning cash at a considerably lower rate than the tax code currently allows, which is intended to have the impact of giving companies an incentive to bring it back to the United States.

Ruggiero of R.W. Pressprich said that “actually, there are some credits that we follow out there whose cash is largely locked up overseas and are junk-rated and otherwise would benefit from a lower repatriation tax, so they could come back [with the cash], redeem debt, reduce their interest burden inside the guidelines for the new tax code relating to interest deductability.” He said that this could be “a win for the companies, a win for reducing the risk of default, and a win for noteholders, if some of these notes are taken out.”

That having been said, however, he cautioned that while this could help some junk credits, most high-yield companies tend to be smaller, without substantial foreign operations, so “I don’t know if the benefit is as substantial as it is for the Dow 30 or the S&P 500,” most of which tend to be bigger investment-grade companies. Still, he said, there are those [high-yield] credits that have international subsidiaries where cash is locked up and this could otherwise benefit the corporations in reducing default risks in some specific situations.”

Odeon Capital’s Van Alstyne said that he was “nervous that the tax cut was priced in already – that ‘buy the rumor, sell the news’ might be the effect of them finally passing it.”

He said that while the tax cut provisions aimed at encouraging companies to bring their overseas cash home and discouraging them from pursuing corporate tax inversion maneuvers – a number of traditionally U.S.-based companies have in recent years moved to Ireland, Canada or other foreign domiciles to escape getting a big tax bill from Uncle Sam – could be “really a positive for the country because of that.”

However, he said that it was unclear how much that might actually affect bond or stock prices of such companies.

“It’s almost inconsequential to an investor where their investment is domiciled, because when you make the investment, especially in high yield, you’re basically assuming the company is not going to be profitable – when you build in your worst-case scenario, you say “OK, can they afford their coupons – are they going to pay me back?” You don’t care so much about profitability or taxation.”

Another question is whether the net impact of the tax cut program will aid average taxpayers by reducing the government’s tax bite and putting more money in their wallets on payday, which in turn could theoretically aid sectors of the economy dependent on consumer spending – areas such as retailing and restaurants, travel and leisure, or perhaps even big-ticket purchases like cars or housing.

Tax impact debated

KDP’s Penniman believes “it’s going to depend on how this is sold – because right now, certain people who have been very successful are saying that this is not a tax break for the population, it’s a tax break for corporates, which obviously it definitely is.

“But I think for the most part, given where consumer sentiment is, we would expect to see more consumer spending – it just may not be in your traditional retail and supermarkets.”

Ruggiero agreed with the idea that whatever tax bill, if any, may be signed into law, “corporations are clearly going to benefit.”

He said that while any kind of a tax cut “is going to have a multiplier effect within the economy,” the question of just who will get how much of the benefits from that – and whether that will translate into positive developments for specific sectors, such as say, consumer-oriented businesses – at this point remains up in the air, and he declined to speculate on how the tax changes might affect specific sectors.

He did express some doubt about the idea that the tax law changes might produce “some broad consumer benefit – I don’t know.”

One of the traders said that “it’s tough to say” what impact the tax changes might have on the consumer.

He cited the concerns over the deductibility of state and local income and property taxes – the final version of the bill does allow filers to deduct up to $10,000 of such taxes, although they are forced to make a choice of one tax versus the other rather than combine all such taxes, as in the past.

“It’s questionable whether people will actually have more money that they will be spending,” he said.

He said that it was possible that “the companies, with a little more cash coming through, may become more competitive in terms of pricing, and may have some more cash to do some more consolidation.”

He predicted that “net-net, I think the tax changes will be positive for the issuers of the high-yield market, either directly from an income point of view – less taxation – or possibly from additional revenues from consumer spending.

“But it will be a benefit – I don’t see how it becomes a detriment.”

What lies ahead

Looking at the overall high-yield market, that trader said that “it’s hard to imagine – I don’t foresee high yield having a performance like 2017. I’m personally more in the coupon area, which ideally is 4% to 5%. I find it difficult to believe that spreads are going to be able to contract much more than they have. I think we got to as tight as 380 [bps] on average – we’re probably a little bit off of that now.”

He projected that “we will see some upward movement in Treasury rates, so I just don’t think there’s a lot of capital gains, a lot of capital appreciation within the high-yield space. I think it will be more income related. I do envision the market being pretty stable.”

A majority of those queried by Prospect News would agree with that particular prediction of an overall return of somewhere around 4%, 5% or maybe 6% tops, although a trader at another shop added “but if you bought during one of our volatile periods, you could do better.”

He also suggested that “having 5% to 7% [of an investor’s portfolio] in cash right now is probably a shrewd strategy.”

He continued “I don’t think we’re going to see much price appreciation. I think you’ll be happy collecting all or part of your coupon, less price volatility, which brings you below the average coupon, and I would guess the average coupon is somewhere in the low 5s, So I think next year you’ll be happy if you get the coupon.”

A bad moon-a-rising

Even that may be a bit too optimistic, yet another trader warned.

He said that while the junk market behaved “fabulously” in 2017 and “proved a lot of people wrong,” and people would continue to reach for yield and thus invest in high yield, “I don’t know if it’s going to be that way in the future – we’re going to have a correction at some point in stocks and in the economy.”

He called the current political climate in the U.S. “toxic – not much of a testament to fair-minded people,” and predicted that nothing positive would come from the “vindictive” climate of in-fighting.

He called the junk market “just tremendously overpriced – it’s got the best of things priced into it.

“When it does finally turn, it’s going to be a real messy situation, because I don’t see much liquidity in it. A lot of people are going to be trapped – which is not a good position to be in.

“Forget about getting out at a discount to where you think you can get out at – you won’t be able to get out at all.”

He theorized that “I think it could really be ugly. It’s painful to forego income and opportunity when it appears like it is all around you – but sometimes, things can be deceiving.”

As to what kind of return investors can expect, he cautioned that “we could see negative returns – even without a major negative credit event” such as was seen in 2008 or 2014-15.

Where to go – or not

Most others we spoke to were not quite so negative and had ideas about how to maximize returns.

One of the traders, for instance, is “cautiously optimistic” about energy, noting that “in the early part of the year, you had that little swoon [down to $42 per barrel] that took all of the oil names down – but then they started to rebound, and they’re way off the deck from the beginning of the year.”

He said that OPEC “looks like it’s going to play along” with efforts to cut output and boost crude prices, which in turn would help the sector.

He also said that “selective health care might bear a look” – while more leveraged issues like Community Health Systems Inc. “got hammered,” more stable sector names like HCA Inc. “have held in there well because they have a lot of BB and secured paper.”

At another shop, a trader chose not to mention particular sectors – but stressed that “I think I would look to be over-weight on single-B credits. Nothing jumps out at the moment as to specific sectors – but over-weight single-B credits.”

On the downside, he did get specific about one sector to probably steer clear of. “We’ve seen the [telecom] wirelines really struggle and that’s an area that, given cord-cutting, given wireless, given other means, it feels like there’s not a lot of real upside to those types of companies at this point.

“There’s big debt loads in Frontier Communications Corp. and several other names, that being one of the bigger ones in the space that’s come under pressure.”

And he indicated that the conventional wisdom of sticking with short-duration credits might not be a favorable strategy.

“I would say it’s a crowded trade and it kind of always has been and it continues to be, so you’re really not getting a lot of juice out of short-duration type exposure and it’s very difficult to source, given the fact that that’s what’s sought after.”

Yet another trader took the exact opposite tack, rhetorically saying “what do I like? I like short duration.”

Names to watch

As to more specific recommendations, he said that “one name that I think has been beaten up and that I think people should look at is PetSmart Inc. The 5 7/8%, which is a first-lien piece of paper, has a shorter maturity and is trading at a 15-point discount.”

He noted that PetSmart “merged with Chewy.com, and if you talk to a lot of pet owners, they’ve switched from Amazon to Chewy as a site for where they purchase their dog food, their kitty litter, their cat food and other products, because Chewy has a knowledgeable telephonic sales force that pet owners can ask questions of or ask suggestions on products, over the counter medical products for coat problems or whatever.

“Because it’s a $1.3 billion issue that was priced aggressively when it came and was heavily placed with the ETFs, it had the recipe for a name that was going to be sold every time there was a downdraft, and that’s what happened. So, you’ve got a credit that was unfairly beat up. So that’s one that I would look at, in the retail space.”

He also gave a positive mention to Precision Drilling, Approach Resources and some of the shorter Chesapeake Energy Corp. paper.

“But really, it’s not buying sectors, it’s buying specific credits.”

KDP’s Penniman said that many sectors, such as consumer products, media, retail and food “are bifurcated – there are good credits and there are some bad credits.”

He said that investors should be “credit pickers – there is value in certain sectors, you see some companies that are going to be moving up, and some that we’re going to be concerned about their ability.”

As to specific sectors, “I think we like materials. Obviously, the REITS are doing well. Capital goods should do well. Services should do well. Technology in general should be fairly stable.”

And he concluded that “generally, my perception of risk-reward is that the CCCs – which continue to outperform year to date, relative to the benchmarks – that will not continue next year.”

“You didn’t have any micro-crashes; you didn’t have any bubbles popping; you didn’t have any major bankruptcies that seemed to bring the rest of the market down or have a lot of impact.” – Mathew Van Alstyne, co-founder and managing partner at Odeon Capital Group LLC

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