High yield to see slowing supply, shrinking demand and smaller returns, S&P predicts

By Paul A. Harris

St. Louis, July 7 - The U.S. junk market will see a deceleration of new issue supply, reduced demand and dwindling returns, Standard & Poor's said in its mid-year report "U.S. High Yield Outlook: A Delicate Sense Of Equanimity."

The report points to a "fair share of volatility" in the months leading up to the middle of the year, with the primary catalysts being the May downgrades of General Motors Corp. and Ford Motor Co.

The market absorbed the downgrades with relative poise, Diane Vazza, managing director of S&P's Global Fixed Income Research, and her colleagues said in the report.

However, the volatility has driven some issuers away from high yield and into the leveraged loan market.

Both markets have benefited in recent years from abundant liquidity and declining defaults, S&P noted. Despite this - and contrary to the high-yield market - pricing in the leveraged loan market remains compelling, with spreads highly compressed across all major rating categories, while the search for increased returns has prompted lower risk aversion among leveraged loan investors.

Among the main themes in the 2005 speculative-grade bond market is a reduction in high-yield issuance from "its sizzling pace in 2003 and 2004."

S&P predicted that issuance in 2005 will hover near its 10-year average of $83.9 billion. The market saw $37.4 billion of new debt through the end of the second quarter, well below the $56.6 billion and $64.2 billion issued over the same period in 2004 and 2003, respectively.

If the pace of the first seven months of issuance continues, volumes will reach $78.2 billion in 2005, 25.2% lower than the volume seen a year ago, but still 21.1% higher than the deep declines observed in 2002.

"However, the market's appetite for absorbing a swathe of big LBO-related deals currently in the pipeline - SunGard Data Systems, Cablevision Systems Corp., Neiman Marcus Group Inc. and Shopko Stores Inc. among others - could act as a significant wild card for issuance volume," the report added.

One factor constricting potential issuance is a yield curve that will remain flat, albeit at a higher level, limiting the scope for further refinancing activity, especially in comparison with the two previous years. S&P notes that the federal funds rate is expected to rise to 4% by year-end.

Negative fund flows, risk aversion

Meanwhile S&P found demand conditions less favorable than those that prevailed a year ago, with negative flows into high-yield mutual funds and growing risk aversion among investors.

The present "less-than-favorable dynamics" of the market imply low single digit returns for 2005, paling in comparison to last year's 11% gain and the 28% return of 2003.

S&P noted that year to date the Merrill Lynch U.S. High Yield Master II Index has posted returns of only 1%.

Meanwhile credit quality appears to have mostly stabilized in 2005. For the year to June 30, the downgrade ratio - defined as the ratio of downgrades to total rating actions - declined to 57.4%, slightly lower than the 57.9% recorded during the same period in 2004.

Finally, the near-term default outlook is "sanguine," S&P asserted, adding that although default rates will inch up, they will continue to remain well below long-term averages.

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