Outlook 2006: Traders see things going bad - and say that's good

By Paul Deckelman

New York, Dec. 30 - What a difference a year makes.

As 2004 turned into 2005, traders in distressed bonds complained that they were getting bored silly by a lack of anything to do, with default rates and interest rates hovering at historic lows, junk market returns booming along in the double-digits for a second straight year, and a feeling that such troubled names as Delta Air Lines Inc. and Calpine Corp. might actually manage to turn things around, after Delta wrung $1 billion of labor cost concessions out of its pilots' union and staved off bankruptcy with a funding deal, while Calpine chief executive officer Peter Cartwright waxed enthusiastic about the company's ambitious plan to cut its $18 billion debt load by $3 billion by the end of 2005.

Fast forward to the present, which sees both Calpine and Delta having slid into Chapter 11, along with Delta rival Northwest Airlines Corp. Default rates bottomed out in the early part of the year, as predicted, and have begun to climb back upward, although they remain relatively low by historic standards. Interest rates have been climbing steadily, ratcheted upward by the Federal Reserve Board, raising some fears that this could throw a damper on economic activity and hurt the fortunes of some companies. Ditto for high energy prices, particularly gasoline, whose escalating price has simply wrecked the finances of General Motors Corp. and Ford Motor Co., hammering the ratings of both down to junk levels and pushing their bonds well below par.

Looks like things are looking up in the distressed world.

"Hopefully, we're looking at a lot more bankruptcies in 2006 than in 2005," a trader in distressed bonds said, tongue only partially in cheek. "That's what we need."

He said that "everyone in the junk market is liable" to fall into the distressed area "if interest rates go up, right?"

Noting the fact that many of the bonds issued with little or no due diligence by buyers during the heady bond boom of the late 1990s later defaulted, some of the issuers went bankrupt and many - particularly telecommunications start-up companies - went away altogether, the trader predicted that "the same thing is going to happen again," given the huge levels of new issuance over the past three years.

"They're gonna start issuing crap up the wazoo," he continued. "They already have. They're issuing stuff that people aren't even reading, and a year, two years down the road, who knows what's going to happen?"

Stephen G. Moyer, head of research at Imperial Capital in Beverly Hills, Calif. and the author of Distressed Debt Analysis: Strategies for Speculative Investors, sees a busier year ahead in the distressed markets, noting that "default rates will likely be higher [in 2006 than they were in 2005]. The Moody's model, the Altman model - they're all projecting a pickup in default rates, so that should help distressed activity."

Moody's reported that the global speculative-grade default rate declined in November to 1.8% from 1.9% in October. The ratings agency was projecting that the rate would end 2005 at 1.9%, remain near the 2% level until the 2006 second quarter, and then "is expected to rise at an accelerated rate," with a 3.3% rate seen by the end of this coming November.

The U.S. speculative-grade default rate, which is generally higher than the global rate, was meanwhile unchanged at 2.2% in November. Moody's did not give an estimate for the likely course of the U.S. rate in 2006.

Standard & Poor's said its global corporate speculative-grade bond default rate had slipped to an eight-year low of 1.40% in November. It also forecast that its U.S. speculative-grade default rate, which, like Mood's equivalent rate generally tracks somewhat above the global rate, is on target to rise to 2.8% by the 2006 third quarter.

With more activity in the market, Moyer said, comes more opportunity to make money trading in the securities of companies in trouble.

"I think the savvy guys always seem to be able to make money off volatility, and I expect there will be reasonably high volatility. So I would suspect that distressed returns will exceed those of the high-yield market generally," which most analysts and traders anticipate will again be in single-digit percentage point territory.

"But I also think that the distribution of returns among the hedge fund managers that are focused on distressed will be significantly wider in terms of standard deviation than the returns of, say, high yield mutual funds" - meaning, essentially, that not everybody will enjoy the same level of success.

The fate of recent junk deals

With high yield new issuance having topped $100 billion in each of the past three years, including 2004's record of more than $150 billion of new junk paper, Moyer noted the fact that "a disproportionate amount of the new issuance was rated single-B or lower. History says that 40% of these will default in the first three years after issuance," meaning busy times ahead for denizens of the distressed debt markets.

However, Kingman D. Penniman, founder and president of KDP Investment Advisors Inc. is less certain that the trends of rising default rates and hefty new issuance necessarily translates into a pick up in distressed-market activity.

"Obviously, when we look at default rates where they are, near historical lows, they have only one place to go, which is up. But to say that we're going to get back into the kind of environment that we saw in 2001-2002, I don't foresee that happening any time soon," he said.

While some in the market have speculated that the heavy issuance of the late 1990s - including much by low-rated, financially shaky start-up companies - would result in more credit problems when those issues started coming due say seven years down the pike, it would seem that those issuers who were going to have problems have already had them, several years ago. If an issue has hung on long enough to reach maturity, it likely would be redeemed or refinanced, in most cases.

Given the lower interest rates of the past several years, and the heavy new issuance in 2003 and 2004, Penniman said that "a lot of the credits, the class of '98 and '99 when there was a lot of new issuance, these are a lot of the credits that have done a lot of refinancing. They were able to refi and extend their maturities and do it at lower cost."

As a result, these bonds are not starting to come due round about now.

The KDP chief sees some credit problems ahead - but not anytime soon. He opined that "the class of 'future distressed' is likely to be part of the issuance of 2006, which we haven't even seen yet. I think we're going to see a lot of M&A and LBO issuance [in 2006], and I think that's something we may see [distressed] in 2007 and 2008, but we don't see that kind of distressed in 2006."

If anything, he brushed off the talk that this upcoming year would be busier in the distressed precincts as mostly wishful thinking on the part of traders and other market participants in this area.

"They're trying to talk something in there. I think the chances are that some companies may not have the flexibility or the time that they usually have. I think you have hedge funds and other people's activities that are trying to create direction, whether it's up or down, they can put pressure, but I hear more distressed people looking for things to do. They may be talking about building their staff, but they don't seem to be hiring it yet, because I don't think there's a lot of supply out there yet for all the money that they'd like to chase."

Airlines under the spotlight

Even so, there are definite areas of interest out there in the distressed markets. A major one is the airline industry. Three of the largest U.S. carriers are at this time in Chapter 11 - United Airlines, the second-largest carrier, Number-Three Delta and Number-Four Northwest. The latter's bonds are currently trading in the upper 30s, Delta's notes are concentrated around 20, and UAL - which earlier in 2005 languished in the mid-single-digits - had managed to steadily gain altitude and was hovering in the upper teens by year-end, given wings by the company's progress in its restructuring. It entered Chapter 11 in December 2002, but is finally expected to emerge in the 2006 first quarter.

Airline industry analyst Ray Neidl of Calyon Securities is of the opinion that the airline industry environment "seems to be more stable, now that speculation regarding possible bankruptcies is out of the way, with Delta and Northwest filing for Chapter 11 and the threat of additional ones having receded for the time being."

Neidl - whose company hosted an airline industry conference in early December in New York at which executives from a number of airlines made presentation - said that industry expectations are that capacity will come down in 2006, as airlines have adjusted their operations to eliminate underperforming routes. This is an important step in an industry long plagued by overcapacity. Delta, in particular, recently announced plans to revamp its operations, including ending its low-cost Song airline unit, and other airlines have also been grounding flights and taking out capacity.

Neidl said that revenue per available seat mile, the key economic performance metric in the industry, "is increasing at a strong pace year-over-year, off a low base. Traffic and the economy remain strong."

However, he indicated that the major uncertainty for the industry remains in oil prices, which are considered a reliable leading indicator of future jet fuel price trends. Crude oil, which had briefly broken above $70 per barrel in the fall, has since fallen back to a range in the upper $50s to slightly above $60.

"At least it is not increasing for the time being," he noted. "The lack of any additional bad news is actually being perceived by the market as good news for the industry."

The one fly in the ointment for the recovery of the traditional old-line carriers such as UAL, Delta and Northwest and their non-bankrupt rivals such as American Airlines and Continental Airlines remains the low-cost carriers like Southwest Airlines and JetBlue, which over the past few years have been eating the traditional carriers' lunch.

Neidl said in a recent research note that if the low-cost operators try to step in and fill the void created by the majors' capacity reduction efforts, it would undermine those efforts by the major carriers to regain some pricing control by cutting the supply of available airline seats. However, he stated, "It appears as if the low-cost carriers would have a difficult time stepping up their already aggressive growth plans to fill any void left by major carrier reductions." He cited the impact of high oil prices "and the fact that aircraft production lines are full for the next two years."

In the long run, however, "the elimination of additional carriers, though merger or liquidation, and [the elimination] of some of their surplus hub systems is needed if any true pricing control is ever to be obtained more permanently," he cautioned. Steps were taken along those lines in 2005 when US Airways emerged from bankruptcy and merged with AmericaWest, and when Southwest, the low-cost segment industry leader, acquired a commanding stake in the bankrupt ATA Airlines.

Imperial's Moyer, meanwhile expressed concern that with United, Delta and Northwest already in bankruptcy a key question mark would be AMR Corp., the parent of American Airlines, and Continental, which he terms "the big ones that aren't in bankruptcy." While industry leader AMR is widely considered to have dodged the bankruptcy bullet in 2004, when it managed to wring hefty concessions from its pilots and other employee unions, the analyst rhetorically asked "can American and Continental still hold out after their competitors go through yet another round of even stiffer labor concessions from their unions, material reductions of their retiree obligations and healthcare costs and rejections of leases on inefficient aircraft as a result of a Chapter 11 process? If they don't file, these will be significant challenges for American and Continental."

He further pointed out that as long as United remains under court protection, and with Delta and Northwest having just recently begun their respective reorganization processes, "from an operating cost perspective, they aren't burdened by the need to cover their interest. They fundamentally have a different operating model right now," than do American and Continental. While fares have gone up due to higher fuel costs, "airlines going through a bankruptcy will have more pricing flexibility due to lower operating and financing costs."

Watching the automakers

Elsewhere, distressed investors will be following the latest developments out of Detroit, which will determine whether GM and Ford stay distressed of climb out of their current hole.

The Number-1 and Number-2 U.S. carmakers' ratings were cut to junk status in 2005, and their benchmark bonds driven down to levels around 70 cents on the dollar amid an ocean of red ink brought on by sagging car and SUV sales, escalating prices for raw materials such as plastics and steel, and increasingly burdensome employee healthcare expenditures. Ford was also forced to bail out its troubled former subsidiary, Visteon Corp. while GM's former subsidiary, Delphi Corp., was forced into Chapter 11; Delphi remains hopeful GM will agree to take some plants and highly-paid employees off its hands the way Ford did for Visteon.

KDP's Penniman believes that GM - which set as a goal the sale of a majority stake in its General Motors Acceptance Corp. financial arm, both to raise GMAC's ratings back to investment grade from junk and thus cut its borrowing costs, as well as to bring anywhere from $10 billion to $15 billion into the money-losing GM's coffers, depleted as they have been by sagging North American vehicle sales - will succeed in its effort, even though several rock-solid financial companies which had been mentioned as potential buyers for control of GMAC, such as Bank of America, Wells Fargo & Co. and Citigroup have indicated no desire to become involved.

He also was of the opinion that GM "is going to do some things that are necessary to come in and basically subsidize Delphi to a certain extent, so there won't be a strike." The possibility that employees of the bankrupt Troy, Mich.-based automotive electronics manufacturer might walk out in opposition to Delphi's efforts to drastically lower its labor costs by getting its hourly workers to accept far less in the way of pay and benefits than they currently do (under labor agreements inherited from former parent GM) has roiled the junk market and contributed to weakness across the entire automotive sector.

So, said Penniman, "If those two factors happen [the sale of the GMAC stake and GM assistance to Delphi], a significant hangover on the market will have been lifted."

Others, however, are not so sure that the junk market's GM problem will go away so quietly.

"You're seeing retail [investors] having to get out of this paper," a trader said of the automotive issues generally, including GM, "or at least a lot of it. You heard earlier in the year, when they were getting notched down from investment grade to split-rated to crossover, they had to get out of it, and you saw a lot of that. Now, even at the end of the year, we're seeing a lot of 'bid wanted' stuff, people have just given up on the credit."

Going forward into 2006, he said, "GM and Ford should still be active. You look at the numbers [their bond price levels], and there's speculation, either that they make it and these numbers are so cheap that you're going to have a windfall, or the other side of the coin, where they have their problems, whether they get their concessions from the United Auto Workers, whether they're able to manage their healthcare costs, or their production or their sales. If they don't - they're going into the tank. So it should be interesting."

It is a measure of how far the once-mighty GM's fortunes have fallen that the word "bankruptcy" can even be seriously mentioned in the same sentence with the name of the iconic American industrial giant, of whom its then-chief executive officer, Charles E. "Engine Charlie" Wilson - later secretary of defense during the Eisenhower administration - famously said in the early 1950s that "what's good for America is good for General Motors, and vice versa."

The trader himself does not personally believe "there's even a chance" that the world's largest carmaker might wind up following former unit Delphi into the bankruptcy courts - but he noted the recent news that New York University business professor Edward Altman, a noted economic forecaster, said that GM had notched a poor score on an index he had devised to predict the possibility of a company going bankrupt. Using data derived from their financial statements, Altman's index rates companies with a score of 3.0 or better as highly unlikely to go bankrupt, and companies scoring 1.8 or below as more likely to fail - and he said GM had scored no better than 0.84, based on its third-quarter financial report. By Altman's standards, that means GM has about a 15% chance of filing for Chapter 11 in 2006 - and a 47% chance of doing so within the next five years.

"It's a very weak number," the trader said of GM's score on the "Altman Z" index." He added "at least according to the parameters of his formula, that down the road, not saying in the next year, '06, it's certainly a possibility. But, who would have ever thought that?" However, he reiterated his skepticism about a possible GM filing.

Imperial Capital's Moyer said that GM faces "a tough road.

"I know they've got a ton of cash. I know it's GM. But I think it's a pretty tough environment - and the same basic issues that have taken down many of the larger suppliers," such as Delphi, Collins & Aikman Corp. and Tower Automotive Inc., "afflict GM. It just has a little bit more liquidity and was higher up on the food chain, so that in the last couple of years, GM's been able to squeeze the suppliers to keep itself alive. But it's a very challenging environment out there, negotiations with Delphi and the UAW are tense, legacy pension and health care costs are high and it has significant, underutilized domestic plant capacity. And it seems pretty clear that in the current political climate, there's no such thing as 'too big to fail'."

He added that "it's certainly safe to say that GM bonds have fallen into the trading range where the market clearly sees risk going forward."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.