Outlook 2011: High-yield secondary to have decent year as rates stay low, inflows continue

By Paul Deckelman

New York, Dec. 31 - They said that the 2010 high-yield secondary market would come nowhere near matching the great results put up in 2009 - and they were absolutely correct.

But the ubiquitous "they" - as in the exponents of the conventional wisdom - also predicted that 2010 would at best, be a mediocre year, with most experts suggesting that investors would perhaps earn their coupons but not much more. They projected that 2009's momentum would gradually die down as the fund flows that had buoyed junk pretty much dried up - but in this, "they" were quite wrong.

Market participants surveyed by Prospect News for the most part were pleasantly surprised by the relatively strong performance which the junk market turned in during 2010, helped along by continued low default and interest rates - and the role the latter played in holding down returns available from other classes of fixed-income assets, making junk by far a relative-value winner.

Flows of money into the junk market continued pretty much all year, creating a comfortable environment for both record new issuance and good secondary market performance for most of that new paper.

As for the year to come, most of the traders, portfolio managers, sellside sources and other junk marketeers to whom Prospect News contacted believe that high yield will see another at least decent year as current conditions more or less continue, barring any unforeseen macroeconomic disasters, and at least for now, the flow of funds into junk will also continue.

Not unlike the majority of the predictions seen heading into 2010, the general consensus seems to be for 2011 returns in the mid-single digits on a percentage basis, with bonds earning the coupon but not seeing much in the way of capital appreciation - although here and there were expectations that a third year of double-digit percentage returns was not entirely out of the question.

The tale of the tape

Although the phrase "don't touch my junk!" caught the public's attention and became something of a rallying cry late in the year for airport travelers dismayed by the prospects of overly intrusive body searches, it certainly never caught on in the financial markets, where quite a few people were touching junk all year round, and profiting from it.

High-yield market performance in 2010 was unexpectedly solid, according to widely followed statistical measures.

The Merrill Lynch U.S. High Yield Master II Index, for instance, closed on Wednesday, Dec. 29, sporting a year-to-date total return of 14.924% - admittedly nowhere near the 57.512% return recorded on Dec. 31, 2009, but then again, nobody was expecting it to be, and that 2010 total return figure topped most estimates.

The Index was in positive territory for virtually the whole year, except for several sessions in early February when it dipped briefly into the red, bottoming at a loss of 0.357% on Feb. 12 and then roaring back into the black over the following weeks and months. It hit a peak return of 15.602% on Nov. 9, declined after that to a temporary trough of 13.197% on Nov. 30 - but turned back upward after that, including a streak of successive gains as December came to a close.

Other measures tracked by the Master II showed similar mostly upward trajectories. The average price of a tracked issue, which had finished 2009 at 95.468, was closing out 2010 at 101.523, while the index value went from 684.983 at year-end 2009 to 787.107 on Dec. 29 of this year - both showing solid improvement year over year, though they were finishing down somewhat from their Nov. 9 peaks of 103.385 and 791.583, respectively.

Bond yields and spreads, which show improvement by declining rather than increasing, also did so during 2010. The Master II's yield to worst, which had closed out 2009 at 9.047%, was finishing 2010 at 7.442%, while the index's spread to worst likewise tightened smartly, ending 2010 at 557 bps over comparable Treasuries, versus a 650 bps spread a year earlier. Both of those measures also showed a modest widening from where they had stood on Nov. 9, but like the other ML Index measures, were improving markedly over a number of consecutive sessions to close out the year.

Looking at other market measures, the Markit CDX North American HY Index, which had closed out 2009 with a 99.271 price reading, stood at 102.76 at the close on Dec. 29.

The KDP High Yield Daily Index, which had finished on Dec. 31, 2009 at 71.13, with a yield of 8.09%, had improved over the next 12 months to 74.24 on Dec. 29, while its yield had come in to 7.36%.

Want a reason? Pick any one

Kingman D. Penniman, the president and chief executive officer of Montpelier, Vt.-based KDP Investment Advisors, Inc., the research firm which puts out the daily index, attributed the year's strong double-digit gains - somewhat above KDP's projection of 2010 returns of perhaps in the 10% to 11% range - to "a demand for yield in a low-yield environment, very strong technicals and a lot of liquidity." He also noted the role that continued low interest rates played in the year's strong showing.

Gary A. Russell, a managing director and high-yield portfolio manager for New York-based DWS Investments, suggested that "if you look historically, after a rally like we had the year prior [2009], the following year also usually had a pretty good return, with coupon-plus or yield-plus returns.

He said that DWS - Deutsche Bank Group's U.S. retail asset management firm - had been looking for a "coupon-plus" return above the 9% average 2009 year-end yield, for a return around 11% or 12%, "so I think we're in the neighborhood where we thought it would be."

Russell noted the role that continued low default rates - which have dropped sharply since late 2009 to around the historical averages - played in the strong market showing, declaring "if defaults are low, or are expected to go considerably lower, below historical averages, that's what ends up driving returns in high yield."

Mathew Van Alstyne, chief of research for Odeon CapitalGroup LLC, a New York-based boutique broker/dealer, investment banking and asset management firm, called 2010's performance "just a matter of timing - we came into the year with still room to run from the bottom of the [2007-08] crisis. When the crisis started to abate, it was higher assets - AAA, AA, single-A, everything started to rally as you went down the risk curve. You entered the year with room to run - that's basically all it was, and it ran. These bonds had room in their prices to move up as you entered the year.

"If we had entered the year [with bond prices where they were] on, say May 1 instead of Jan. 1, then you might have had less room [to run] because you already had moved more.

"But the risk-reward is what people look at - you look at relative value, and high yield had greater relative value than investment grade."

Kete Cockrell, the head of high yield capital markets for RBC Capital Markets Corp., a New York-based arm of Royal Bank of Canada, said that the junk market's strength throughout the year was chiefly attributable to a delicate balancing act between two competing factors - inflation remaining in check, while at the same time, the economy was just strong enough to avoid slipping back toward a "double-dip" downturn.

"That kind of balance was what made the market so strong throughout the entire year. All of us were questioning whether that equilibrium could be maintained for a full 12 months - and every time during the last 12 months when you saw that equilibrium get out of whack, either through a macroeconomic issue that was coming about, or an economic indicator that would indicate one versus the other, we saw that push-pull throughout the year."

He said that beginning around the middle of summer, "there was this view that for the foreseeable future, we were going to see muted inflation, but we were going to [also] see growth, albeit very light growth - which is perfect for debt, right?"

A better-than-expected year

A veteran trader acknowledged that 2010 "turned out to be better than expected, that's for sure," since junk was able to maintain its momentum off "the extraordinary returns last year [2009]."

He said that "the underlying improvement in the market wasn't as much spread contraction as it was the decline in Treasury yields - I think that as yields dropped, Treasuries and, in turn, better-quality corporate debt motivated investors to go in search of higher yield."

He said that given the backdrop of a slowly recovering economy, "their comfort level was better than usual and the lack of headline defaults this year allowed investors to absorb a higher level of risk than they would have done in normal times." However, he added, "if interest rates weren't so low in Treasuries and other safer investments, I don't know if high yield would have performed as well."

Another trader simply chalked 2010 up as "a weird year. I can't believe where the market ended up at the year's end," adding that "that's what happens when you have tons and tons of inflows chasing yield."

Liquidity leads the way

As had been the case in 2009, there was no shortage of liquidity in Junkbondland.

According to the AMG statistics compiled by Lipper/FMI, inflows to weekly reporting high-yield mutual funds had racked up a cumulative year-to-date net inflow of $10.472 billion as of the week ended Wednesday, Dec. 22 - only around half of the more than $20 billion seen the previous year, but way more than enough to support both record primary issuance of nearly $300 billion as well as a robust junk secondary market.

While the mutual funds make up only a relatively small portion of the total monies circulating around the high-yield market, they are more easily measurable and trackable than other sources, making them an efficient barometer of junk market liquidity trends.

As had been the case in 2009, net inflows to the funds were seen pretty much throughout the year, recorded in 36 of the 51 weeks up to Dec. 22, with net outflows seen in the remaining 15 weeks.

There was one stretch of net inflows seen over a 10-week span from mid-February to late April, during which some $4.4 billion more came into those funds than left them, and another from early September through early November which saw more than $5.6 billion of net inflows.

On the other hand, there were six weeks of net outflows from early May through mid-June, totaling about $4.6 billion, and a three-week stretch in November and early December that saw a total cash bleed of around $2 billion. That was offset by nearly $2 billion of inflows seen over the following three weeks in December, including the $438.7 million inflow seen in the week ended Dec. 22.

Will the money flow continue?

The continued flow of money into the junk market would seem to hold the key to whether junk will hold its own against equities and other asset classes.

For instance, one trader - who believes that the junk market has pretty much had its run and is now fully valued, believes that junk won't be able to do this going forward.

"I think people are going to be starting to funnel more into equities than into bonds," he declared. "The big move has been made - that doesn't mean that [bonds] can't act respectably, but I think that there certainly is a lot more opportunity in the equity than there is in the bond market at this point."

RBC Capital Markets' head of U.S. leveraged finance, Jim Wolfe, believes that as junk as an asset class continues to perform well, cash will continue to come into it.

"You look at this year - the high-yield asset class return is over 14%. Then you look at other alternatives, whether it's cash at virtually zero percent or Treasuries - which have obviously ticked up over the last couple of weeks, but which continue to be at historically low yields - or an equity market that's performing a little bit better, but which continues to lag."

Wolfe noted that the latest fund-flow data available to RBC indicates that as of mid-December, equity funds had lost a whopping $111 billion this year, with most of that money finding its way into fixed income, including the more than $10 billion of inflows seen by the junk funds.

He said "I do think people will continue to put money in the high-yield asset class, just given our low expectation of default rates given where we are from an economic perspective and the fact that you continue to generate outsized returns relative to the other asset classes."

His colleague, Cockrell, suggested rhetorically that assuming the recent junk market dynamics continue, "I would ask you - are you buying stocks? Are you buying investment-grade bonds? Are you buying any of these alternative investments? My guess is you're probably not doing that, and that's indicative of the overall marketplace. Until those things become more attractive on a relative basis, I think people will continue to put their money into high yield as an asset class."

He added, though, that "if that were to change - we're going to see things change."

KDP's Penniman, who also doubles as the president and chief investment officer of the company's affiliated KDP Asset Management division, took note of the recent three-week fund-flow losing streak, as well as the rebound seen over the next three weeks and concluded that "the market is reassessing where it is - clearly, the expectations of what a lot of us thought would happen," following the early November of its second round of quantitative easing, dubbed 'QE2' by some market wags - and 'Titanic' by others - as well as Congress' year-end approval of extension of the Bush-era tax cuts and some other stimulative goodies tacked onto the latter measure, have come in for a second look.

Penniman said that after those recent Washington developments, "lo and behold, we now have a stimulus program that is the same or perhaps a little stronger than it was expected to be. Now everybody is revising upward, and clearly, as we have lower yields and spread compression, interest rates become more important. But the impact this month has already been on investment grade and Treasuries."

Investors, he said, "are still out there looking for a return on cash, as opposed to a total return, and therefore, I think high yield is the only place where spread is left."

While the KDP chief believes that "you may see additional monies coming in," he added that "the question now with the new economic package is whether or not we will see some of the money leave fixed income and move to equity and therefore results in less [junk inflows]. I think we're not going to get the amount of inflows we had this year - but I think there will be enough to satisfy demand and still give you a good return next year."

Where do we go from here?

Penniman said that "there is more interest rate-risk in the market than there is credit risk, and a lot of that has to do with liquidity coming in or out of the market - but I think when you're looking at returns now, depending on your interest rate move and liquidity, which are two variables, when you put it all together, you're probably looking at a 7% or 8% return."

He added that "if you're looking at [a yield of around] 7.50% and you're looking at some continued move for spread compression, that would put you around 7% or 8%."

At Barclays Capital, the high-yield research team headed by the company's co-head of U.S. credit strategy, Bradley Rogoff, noted in a year-end research report that its proprietary high-yield index "has never produced a total return close to its coupon in the past 20 years," always either over-achieving, or else coming in at 6% or below. The report predicted that "despite an environment of low rates, improving fundamentals and high spreads, we do not believe 2011 will break that streak," with a total return of 5% to 6% more likely than a return above 10%.

Barclays opted for the lower choice "based on the modest backup in rates expected by our interest rate strategists and the call-constrained nature of the high-yield market, which is preventing significant spread tightening beyond the rate move."

Odeon Capital's Van Alstyne also sees a return in the mid-to-high single-digits, around a 6% to 8% range. When asked if it was possible for junk to string together three pretty strong years, he said it could be - but quickly added that "we've kind of had a lull in actual defaults and outright bankruptcies, which has in some ways given a false level of comfort to the market, that maybe we're not going to have any - and those can come back and bite you, especially if you're in the wrong sector and the wrong names."

He said that an investor "could have a portfolio where you're just clipping coupons and maybe add a little bit of leverage and get into the double-digits - but then have just one piece of your portfolio go down to bring the entire return negative."

It doesn't have to be that way, "if you're very savvy and do all the right work and avoid weaknesses." But what makes this coming year different from 2010 is that "I don't think you're going to have the price appreciation. This year, for a return just on a yield basis, you could expect to get 5%, 6%, 7%, 8% depending on your allocation, but then you had a lot of appreciation of the underlying assets, which carried the day. It's hard to see how that, on a broader basis, happens again."

At DWS Investments, Russell by no means believes that the rough patch the junk market hit in late November and early December is any indication that its momentum following the big 2009 year has finally begun to dissipate and junk has peaked for now. He is looking for "coupon-like returns for 2011.

If you look at what was going on in November, the market only saw a little bit of a sell-off, given the amount of new issuance, along with what was seen for a couple of weeks on the outflows, although that's turned positive again recently, he said.

"We still see, looking out to next year, it being a carry year - we expect interest rates to remain [at present levels], and the Fed to stay on hold for certainly the first half of the year, and probably into part of the second half, and in that environment, you've got within high yield a very attractive relative yield here, even versus govies right now."

With interest rates predicted to stay relatively low by historic levels, "your carry trade is attractive in a low-rate market." While freely admitting that 2011 will certainly not see the kind of returns notched in 2009, or even in 2010, "given where you are in the cycle where defaults are, macro growth improving, we're still constructive on 2011."

Traders divided on outlook

At the desks, one trader waxed optimistic, asserting "I'm shooting for 10% - you've got your coupon and a little bit of appreciation." He asserted that a key factor would be continued low interest rates, since "I don't see the Fed raising rates soon, because you've got too many people out of work."

He brushed off statistical and anecdotal evidence seeming to suggest the economy was getting better. "I don't care what they say - I just do not see lots of people getting jobs. With that high amount of unemployment, they've got to keep rates low."

At the opposite end of the spectrum, a trader - seeing no more than a 4% to 6% return - morosely likened the high-yield market to "a giant zit that's ready to pop - because how often can these companies sustain these types of [mediocre] earnings going forward?"

He predicted "a very difficult marketplace - I think it will be OK for the next quarter, but six months in, I think the market definitely has some profits to give back in here. You're going to see some profit-taking, you'll see a little capitulation in the market."

He warned that "we just can't have another year like this year - between unemployment, the numbers, housing, this market is just over-valued. These companies can't sustain these levels of where they're trading, based upon their earnings. It just isn't fundamentally acceptable."

Yet another trader was a little less pessimistic, calling the market fully valued but not "way, way, way over-valued with what's happening in the market."

However, he cautioned that if interest rates move at all, market players are more likely to see higher rates than lower ones. He predicted a return of "anywhere from 4% to 8% - the difference is for one you get the coupon and don't lose any capital, while with the other you get the coupon and you lose 4% of the capital."

What's hot - and what's not

Looking at specific areas, one of the traders asserted that while he is "not that afraid of credit risk across the board," he suggests staying with shorter-duration maturities, as "I don't trust the Treasury market on the longer maturities."

He likes oil names, saying they will continue to do well in an environment of strong crude prices - but conversely, natural gas "is still somewhat problematic," as prices lag below $5 per million cubic feet.

"The sectors that always do well in any kind of economic environment, like health care, should do well also." However, he said that "homebuilding probably isn't going anywhere.

"The resource things, everybody still loves - mining stuff, chemicals, especially given all of the international demand - will still do well."

However, he warned, the food retailers "can't seem to get out of their own way, so I wouldn't be high on those" - and he added that he "wasn't even thinking about" the recent slide into Chapter 11 of major northeastern supermarket operator Great Atlantic & Pacific Tea Co.

"I'm not wild about gaming either, as it still looks like it's going to be challenged," he added. "We're going to need to see a continued improvement in the economy - plus they keep building new ones," noting the current push to put casinos into Massachusetts, "which is not going to help the Connecticut casino operators" like Foxwoods and Mohegan Tribal Gaming Authority.

More gains for autos eyed

A second trader thinks the automotive sector "will continue to improve." He said that the bonds of Ford Motor Co. have had "a pretty good run here. I think that probably over the course of the year they get upgraded, maybe to investment grade."

Ford domestic arch-rival General Motors - whose bonds now actually trade as Liquidation Motors Co., the "old" GM that was left holding its debt while its profitable auto operations were separated out into a "new" GM when the company restructured in 2009 - " certainly has got a lot further to go than Ford does, because Ford has already moved," he said.

The trader expects auto sales, now around the 12 million-unit annual pace, to bump up to as much as 13.5 million vehicles in the coming year, as "people have to replace some of these cars that they've put off replacing. So that should bode well for these companies because they're pretty trim at this point."

He also likes financials, sees industrials as fully valued - and sees retail, gaming and other consumer-oriented sectors as "a dangerous place to be - you're at the whims of people's discretionary feelings."

Russell of DWS is looking not to sectors but to ratings baskets, noting that "the way we're positioned, and what we like, is we have a big overweight in single-Bs and an underweight in BBs - not because we're negative on the BBs, but we just think their correlation with Treasuries would be higher, given potentially increasing Treasury rates there."

As for CCC-rated bonds, "we're selective - we like some of the CCCs, while some we're not involved with. But we have a big overweight in single-Bs. Again, that goes back to what we have this year, which is a carry-trade year - yield, coupon-clipping. In that scenario, single-Bs do quite well."

KDP's Penniman opined that "when you're looking at high prices now, over par on average, you're wondering how much upside is left - but I do think that people will be looking at how companies on the investment-grade side are holding a lot of cash, and you would expect to see the possibility that there will be some merger and acquisition activity. I would be looking at places like tech, energy, perhaps retail, and other sectors; the companies may end up actually benefitting from being acquired."

He also noted that as you look at the declining default rate, expectations, I think that you're going to see certain companies continuing to improve, in terms of their ability to roll over leveraged loans and refinance - they're going to continue to pick away at that 'maturity wall,' which will benefit certain of those companies that have a lot of leverage."

Refinancing similarly plays a big part in another trader's strategy; he counseled sticking with "short maturities - three- to four-year maturities that are callable within the next one to three years, for the simple reason that if the market does tank, you're pretty much protected there, because these are so short. And second, you also have the appreciation in there if they refinance them in the next two to three years because they are short and they are currently callable - even though these days being non-call doesn't matter, they just tender for them."

Van Alstyne of Odeon is wary of "the sectors most associated with housing and retail. If the jobless numbers continue to not work in your favor, that's obviously going to affect retail directly. You want to be more involved in areas like utilities where you know you're going to get your money, but something like the high-end consumer store might be someplace I would avoid."

Watching Washington

Van Alstyne is skeptical about the impact the recently approved extension of the tax cuts will have, noting that it's just not a catalyst for the jobs to come back, so it's hard to see where the consumer strength will come from, given where unemployment is."

While calling the tax-cut deal "obviously positive for the economy," the Odeon research chief noted that "it's only a two-year deal - it really doesn't provide the long-term certainty that businesses and investors need to plan."

He further said that government moves to overhaul and tighten financial regulations are "certainly a question mark for dealers, for underwriters, for traders and for secondary firms like ours, because you're not sure what the rules are yet - you have a good assumption, but you could be surprised."

RBC Capital Markets' head of U.S. loan capital markets, Miguel Roman, took a more optimistic view of the tax-cut extension, remaking that "the one macro[economic] event that at least has removed some overhang from over the market is the change in the tax law, in terms of pushing out the existing rates for another two years. There was a big overhang this year in terms of people being concerned around the change in the tax law," which would have seen some, or even possibly all of the lower rates adopted in 2002-2003 expire on Dec. 31, had the current rates not been extended during the congressional "lame duck" session.

Because of that uncertainty that preceded the extension, "we saw a big acceleration of assets that came to the marketplace that [investors] wanted to close or had to close by the end of this year. So I think a lot of activity probably got pushed forward into this year," he said.

With investors now assured that their tax rates will not shoot higher this coming year, Roman said, "I think that removes some overhang [in 2011] as it relates to that risk. So I think it's a positive for the overall market as well."

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