Outlook 2014: Fed tapering to be key driver for junk secondary; returns below 2013 levels eyed

By Paul Deckelman

New York, Dec. 31 - The Fed giveth - and the Fed taketh away.

For a second consecutive year, the Federal Reserve System emerged as a key player - arguably the dominant player - in the high-yield secondary arena. While 2012 had seen Junkbondland set yet another new-issuance record on the primaryside, while the secondary was soaring to unexpected heights, riding on an easy cushion of liquidity provided to the financial system by the U.S. central bank, 2013 turned out to be quite a different animal.

Strong liquidity-fueled market momentum seen through the first five months of the year evaporated in late May and early June, amid investor fears that Fed chairman Ben Bernanke would take to heart the aphorism widely attributed to one of his distant predecessors in that post, William McChesney Martin - who, in fact, had been the Fed chief when Bernanke was born in the early 1950s. Martin had famously declared that the job of the inflation-fighting Fed is "to take away the punch bowl just as the party gets going."

While not exactly proclaiming that the fiesta was over and telling everyone to go home and sober up, Bartender Ben did signal in June that last call might be coming soon, with the Fed intending to begin "tapering" off its $85 billion per month bond-buying binge later in the year, possibly by as early as September. Open confirmation of what everyone had only previously whispered fearfully about threw junk and other financial markets into a tizzy, from which they only slowly recovered, helped by delays in any such tapering as the economy continued to stagger.

After months of will-they-or-won't-they speculation about when tapering would actually begin, and how intense it would be, the Fed in mid-December declared that it would finally begin the tapering process in January, initially reducing its bond-buying by a modest $10 billion a month, while keeping an eye on how the economy reacts before doing further tapering.

Traders, analysts and other high-yield market participants queried by Prospect News told us that one definite focus during the upcoming year will be seeing how the tapering goes - what impact it will have on interest rates and the overall economy and how that might shake out for junk investors, especially since signs of weakness have at this point by no means been banished from the economy.

Accordingly, most of those whom Prospect News spoke to expressed caution, opining that junk market returns during the coming year, while likely staying in positive territory, would be hard-pressed to match even this year's reduced results.

QE3 sets sail

2013 had opened pretty much as 2012 had finished - with the Fed in effect having the market's back by providing generous liquidity to the financial system via the third round of its quantitative easing stimulus program, launched in September. It was nicknamed "QE3" by the wags, a play on the nickname of the famous Cunard ocean liner - thus providing critics of the program with the opportunity to draw snide comparisons to another famed British vessel, the Titanic.

But the junk market enjoyed smooth sailing aboard the QE3, at least for the first five months of the year, with new issuance running as much as 20% ahead of the pace seen a year earlier, and secondary market performance firing on all cylinders as statistical performance measures cruised to new highs for the year up to that point.

But then in late May, the waters began to get choppy, with various analysts, TV pundits and other market watchers suggesting that based on ambiguous statements from the Fed and other indicators, the party might soon be over. Treasury rates began to back up - the benchmark 10-year notes, after opening the year yielding 1.86% and then bottoming at 1.66% in the first days of May, began to move inexorably back up, driven by market fears that quantitative easing would be ended and historically low interest rates would be pushed back upward.

Financial markets, notably equities but also including the junk world, began to stagger amid the increasing chatter through most of June predicting the end of easing. Issuance slowed and indicators retreated from their previous highs, in fact soon moving within the space of a few short weeks to their worst levels for the year.

The widely followed Merrill Lynch High Yield Master II index, for instance, had ended 2012 with an unexpectedly strong return for the year of 15.583%, more than three times its 2011 close at 4.383%. By May 9, it was on pace to easily match or even surpass that 2012 finish, standing at a lofty 5.835% - the level which for many months would prove to be its high-water mark for this year.

Other components of the index were showing equal strength in early May - the average price for covered issues, which had finished 2012 at 104.3528, had jumped to 107.222488, which to this day is still the high point for the year. It yield to worst had declined to 4.986% from 6.083% at the end of 2012, while its spread to worst had tightened to 427 basis points over comparable Treasuries from 523 bps at year-end.

After that early zenith, it was all downhill from there.

By June 25 - just days after Bernanke formally acknowledged after the June Fed meeting that tapering of the QE3 buying would be on tap starting later in the year - the index's year-to-date return had surrendered almost all the gains that it had notched over the previous five months and stood at 0.384%, its low point for the year.

The average price had fallen to its low for the year of 100.4756. The yield to worst had risen to its high point of 6.853%, and the spread to worst had ballooned out by more than 100 bps to 536 bps over Treasuries, its wide point for the year.

The damage would not be fully undone for months to come, although things did eventually return to some semblance of normal - especially once it became apparent that tapering would not actually begin in September, or any time in 2013 for that matter.

As of the close just days before the end of the year on Wednesday, Dec. 18, the year-to-date return had by that time moved back up to 7.015%, although this was below its new year-to-date high of 7.091%, set several days earlier. The average price of 103.234, while well up from its June lows, was nowhere near its early May highs. Likewise, while the yield to worst of 5.663% had picked up almost 120 bps from its level in June, it was still more than 65 bps above its May lows. The spread to worst had tightened to 431 bps, just a little wide of its new 2013 tight level of 425 bps, set just two days before.

Awaiting other shoe to drop

A junk trader looking back over what had happened this year remarked that "I found it interesting that in late May and early June, when there was talk of the Fed doing something, just how strong, quick and violent of a sell-off there was - just the amount of stuff coming in for sale, the price movement and the bids not being there.

Even though realists in the market knew all along that the quantitative easing produced by buying $45 billion of Treasuries and $40 billion of mortgage-backed securities every month could not continue indefinitely - critics likened the arrangement to just printing another $85 billion and dumping it into the economy each month - that intellectual knowledge did not shield junk and other financial markets from the trauma brought on by Bernanke's acknowledgement that program would eventually end by the middle of 2014.

The trader made the somewhat macabre analogy to "having a family member that is terminally ill - everyone is waiting around, knowing that this person is going to pass soon, and [they are] supposedly emotionally ready for the event - but it still hits you, BANG, right in the face, when it actually happens. It's still a traumatic event, even though everyone is sitting around and waiting for it to happen. That's how I would describe what was going on here."

That having been said, Kete Cockrell, the head of high-yield capital markets for RBC Capital Markets Corp., noted that despite "the significant sell-off in the Treasury market, which we also saw in the high-yield market" on the initial Fed signals that the tapering would begin later in the year, what happened in June was "the only truly weaker market conditions in high yield that we saw all year, which is really amazing - that we did not have more volatility than that."

He continued that "with that as a backdrop, the strength came back into the market when it seemed the Fed did not have the stomach to follow through on that in September which they began to signal in July."

Ripple effect on junk market

Besides whatever positive psychological impact the Fed stimulus program has had on the financial markets generally and junk in particular - as exemplified by the almost panicky reaction seen in some quarters when the prospect was raised that it might soon go away and leave investors at the mercy of rising interest rates - the Fed program has had more tangible, though usually less-acknowledged effects on high yield.

For instance, said Mathew Van Alstyne, the co-founder and managing partner in charge of research at New York boutique broker-dealer Odeon Capital Group LLC, the Fed "is massively altering the market, and they're doing it in a way that is disruptive - probably even more than they expected or wanted, is my guess."

His thesis is that by it massive monthly buying of Treasuries and mortgage-backed bonds, the central bank is in effect crowding out other buyers - and pushing them into alternative investment vehicles, a disruption felt up and down the line.

"No one really knows how much of the strength of junk is due to the dearth of other opportunities" for investors buying junk, he asserted.

With the Fed emerging as such a big buyer, sopping up so much of the available Treasuries and mortgage-backed securities, "more and more mortgage and Treasuries buyers are now buying AA-rated corporate bonds or mortgage bonds - so the guys that normally buy that are buying BBB paper, and the guys that buy BBB are buying CCC," or, at least, other junk bonds.

"So it pushes buyers into other asset classes and distorts the actual cost of risk."

He asked rhetorically "how do you invest in a market where you know unilaterally that there's a distortion because of extreme interventions in the marketplace?"

That, he said is "the 'big story' of 2013."

How will the tapering do?

With the Fed having laid out its preliminary tapering plans for 2014 with its Dec. 18 announcement, attention in the market will now turn to how the taper goes - and what market response may be to it.

Kingman D. Penniman, the founder and president of KDP Investment Advisors Inc. in Montpelier, Va., noted what he called "the miscommunication by the Fed in May and June," which he said "really freaked out the market because that's basically where we got the 100 bps increase [in yields] and it's been going back and forth since then."

He took Fed chief Bernanke to task for having "put more oil on the fire," with his remarks following the June 19 Fed meeting, including putting the notion of a tapering as early as September into the minds of many investors.

The chairman's comments, he said, "really spooked the market."

However, once it became apparent that the Fed would not start cutting back on the tapering throttle that early, the markets seemed to recover something of their old swagger - September saw a record monthly junk bond issuance of over $47 billion, as well as strong secondary gains coming out of the traditional mid-summer lull.

And since then, Penniman said, "we seem to have gotten more comfortable and the economy is starting to show signs that we're improving."

He said that the junk world "feels pretty complacent that the end of tapering is not tightening" of key interest rates.

Fed officials have said that they don't expect the central bank to begin raising short-term interest rates from their current near-0% levels until at least 2015 or maybe even not until 2016. They see the Fed's benchmark interest rate, the Fed Funds rate, staying below 2% all the way out to 2016. While the Fed had previously said that it would hold the short-term rates down at least until the jobless rate, now at 7%, falls to 6.5% or below, the official Dec. 18 policy statement said that it would continue to hold those rates near zero "well past" the point when the jobless rate falls to 6.5%.

But however "complacent" junk marketeers may seem now, Penniman said the acid test would be "whether the market is going to behave that way when [tapering] starts and the economy starts to improve. That's the question that's going to determine performance in 2014."

He added that "going forward, the question is how much interest rate risk is there in the marketplace? And where is the best value? And that really comes down to a function of economic outlook and expectations as to whether the Fed is going to be able to control the elimination of QE and concerns about ultimate Fed tightening."

A case for optimism

A trader suggested that "the fact that the Fed is tapering means the economy is stronger. They're not going to undermine the economy. The economy is stronger - otherwise they wouldn't [be tapering]."

He took pains to point out that he is "not a roaring bull, by any stretch of the imagination."

But he said that heading into the new year many junk companies' balance sheets "are just much stronger, and they're buying back debt."

He pointed out that one of the major themes of 2013 in the junk market - apart from the fixation on the Fed - was that "anybody that could re-liquify tried to do it under these terms - and you could see that by the amount of financings. A lot of people have replenished their financial statements and are in great shape."

Besides cleaning up their balance sheets, this trader believes that many junk companies have cleaned up their acts as well - whereas in the past, companies would sometimes go out and borrow way too much money while not necessarily having a firm grasp of whether they could pay it back. That behavior was enabled by giddy, frothy markets where many investors weren't doing their due diligence, which led to all kinds of problems down the line.

The situation now is "I think everybody has learned their lesson, about getting too leveraged, I really do," the trader said.

He said that companies "are running on a much more intelligent level now. And you can see that by the decline in the default rate.

"I don't think that anybody thinks the economy is going to run away in a rampant style - that all of this crazy recklessness [of past years] is going to continue. I think we've all learned our lesson."

He asked rhetorically "should the caution flag be up a little bit? Yes. But think about it - the Fed is not going to undermine the economy, if they didn't see the growth" that would allow them to taper.

Decrying what he termed the "excessive pessimism" exhibited in some corners of the market, he pointed out that people have become "spoiled rotten" by the recent history of super-low interest rates, to the point where there are laments because the 10-year Treasury yield may hit the 3% mark - well up from its lows of earlier in the year but still below historical norms.

"A couple of years ago, would you have even remotely thought that the 10-year would be that low? No. So that's why everybody is spoiled rotten."

On Tuesday, Dec. 17, the 10-year closed at 2.85%. Although that was about double its all-time low of just above 1.4% reached in July of 2012 and well up from its year-ago level of 1.72%, the 10-year had been at 3% as recently as July of 2011, was at 4% in October of 2007 and at 5% in April 2007. It hit its all-time peak level of just under 16% in July of 1981, and remains well below its historical average of 6.56%.

"At those kind of levels, he said, "let's say a Ba company comes to market and let's say it's 250 [bps] off [Treasuries] - 5.5%. Is that bad to come to market [there]? Even though a lot of companies have taken advantage of these lower rates, I think that you're heading into 2014 where the balance sheets are pretty much replenished. If there's a major dip in the market, these guys can buy their debt back. And in addition, there's still going to be ample opportunity for refinancing."

He predicted that investors will likely generate returns around the 5% area in the upcoming year.

"It's not great but still, you end up clipping the coupon - and that's what you did this year. Look at all of the opinions you hear about the stock market - some people think it's going to go to hell in a hand basket, while others think 'here we go." I just think you have to look at everything in perspective and look at interest rates, and see how historically low they still are."

Low single-digit returns

That same 5% area was where many of the sources that Prospect News spoke to saw 2014 returns coming in. With one exception, nobody saw the market having a particularly bad year ahead - but no one saw a lot of upside.

A trader opined "I'd say 5% or 6% for next year [2014]. I think we'll give a little principal as rates back up, but I don't think next year is going to be a 2% to 3% year by any stretch of the imagination."

He noted that a common statement by junk investors is that they are "looking for coupon-type returns" - to which he asked "what's the average coupon? The average coupon is somewhere in the mid-6s to low-7s - so I don't know if we'll earn the coupon next year."

As for the year just past, he said, "it met my expectations - maybe there was a tad of underperformance, but overall, it met my expectations. I was looking somewhere in the 7% area."

He said that investors who were long single-Bs and CCCs while underweighting BBs "had a good year, if you had that right, and if you avoided the 4% [type] coupon in the middle of the year - stuff like Ball Corp. (whose upsized $1 billion of 10.5-year notes priced at par to yield 4% on May 9) and Constellation Brands, Inc. (whose $1.55 billion of new 3¾% and 4¼% notes priced on April 30).

"Those deals really hurt people. And if you weren't involved in energy ventures, that was a big plus."

KDP's Penniman, who correctly predicted that this year's market would come in somewhere in the 5% to 7% range, said that "given where we are today, and given where the yields are, and spreads - because we're still in a low-yield environment but spreads are still wide to where we were in this type of economic scenario from 2003 to 2007 - I think the expectation is that if we do 4% to 5%, or 4% to 6%, we'd be doing well."

However, he noted the plethora of recent junk bond deals carry historically low coupons - estimating that anywhere from about 60% to 70% of the junk issues normally trade inside of 6%.

With those kinds of numbers, he cautioned, "I think [the 2014 return] is going to be closer to 5%."

Odeon Capital's Mat Van Alstyne said that "5% would really be a great year" - but he said that given current conditions, the 4% to 5% range would be more likely.

He said that in 2013, junk kind of performed like you would expect, with that much intervention that's going on in the marketplace."

While the stock market outperformed high yield, junk outperformed other fixed-income classes, as usual, he said, noting "of course, it's going to outperform, you've got a higher coupon. And we didn't have any major defaults. I can't think of any major bankruptcies that hurt the overall junk yield.

"So you had the spread, it tightened against Treasuries, and the coupon would obviously give you a nice return. So, in terms of fixed-income, it was definitely the best asset class to be in. But the question is whether that will continue when the Fed tapers in 2014."

One of the traders said that "although I don't think the market will have great volatility, I don't see how it gets a higher return than this year.

"If they're thinking a 6% or 7% return this year, I don't see you being able to match that. I don't think so."

While allowing that the junk market "can always grind stronger, that rate of return is going to be so much more difficult to move that paper. If you have a positive return, and you're in that 3% to 5%, or 4% to 5%, with the coupon built into that - not just on price appreciation, from par to 103 or 104, something like that - I don't know how much this stuff is going to jump any more, how much of a move you're going to have."

RBC's Cockrell declined to make a specific numerical prediction for the junk market's 2014 return, saying with a laugh that "if I could really predict that with incredible accuracy, I would probably be doing something else for a living where I was compensated handsomely for making such accurate predictions."

However, he did say that "high yield still has the potential to return something that's attractive in 2014. Most people are pointing to that being somewhere in the neighborhood of the coupon that you see on high-yield bonds today," which averages about 5 5/8%.

He called such assessments "very realistic," even in an environment which could see 10-year Treasuries going from present levels around 2.80% to the 3.60% neighborhood.

A case for pessimism

One of the traders, though, was taking a different, darker tack than his peers.

"I think we'll be down 5% to 10%," he warned. He said that he had "seen that model where you have a 100 basis point shift, and it would affect the principal, not counting that you're collecting a coupon, though.

"This year, when you say the market was up 6%, was it that the market was flat and you collected a coupon - or was it really up 11% or 12%, appreciation on top of the coupon? Here, I just think we're finally going to start dipping into principal losses.

He said that 2014s losses would be driven by all kinds of bad-news events, "starting in January. You've got the debt ceiling. After the nonsense that went on in September and October, it may be worse this time, who knows? Then you've got the health care thing potentially blowing up one-sixth of the economy - it could just get really nasty. There are just so many unknowns out there that look like they may not have happy endings."

He was also not very impressed with arguments that the Fed's tapering off of its QE3 easing will be benign because it has been widely expected and is essentially baked in.

"You still have everyone saying 'we're prepared, we're prepared, we're ready for it, we think it's going to be orderly' - but it's when you come in that one morning and all of the big boys decide 'this is it, we're getting out' and the sell orders start coming. Here come the sheep - everyone's chasing the leader out the door."

He suggested that the market might take its lead from some notable investment guru, "someone like Bill Gross, or it could take someone like Carl Icahn on Twitter saying something. A couple of weeks ago, Icahn said on Twitter he thought the tech space was overpriced - and the market sold off. You just never know what's going to cause it to crack.

"It will be interesting to see if history repeats itself - at some point [the Fed] has to stop buying and at some point, rates are going to go back up, and it's just a matter of whether this model, or play that everyone is doing now - when do they unwind that? When one person starts unwinding, when does the avalanche effect happen - where it gets to the point where everybody says 'we're out'?"

Playing it safe

The contrarian trader urged investors to "keep it short, keep it safe and keep it liquid - stay in the big, liquid names that have a good holders' base, not one of these names where three large funds own the whole issue, because if you decide to sell and those guys are full, you're hosed. Hop on the slide because that thing is going down.

"You see it every cycle - a lot of the portfolio managers say 'I'm going to buy these smaller issues - I know they're less liquid but I'm earning 20 or 50 basis points more for that." When you hit a bad year, those get killed. There's such a lack of liquidity that one seller can drive the market down. In the less-liquid issuers with fewer holders, one seller getting out can really drive the price down.

"I'd stay in the shorter-maturity paper so you're going to not get that hurt when there is some type of correction."

How healthy is health care?

Among specific sectors, he called health care "kind of like the elephant in the room - the health care law could be one of the issues that cracks this market. I think trying to play that sector or those industries with the current administration, things are moving around and changing too much to lay any big bets."

When all is said and done, and figured out whether it's going to work or not work, he predicted, "there will be some fortunes made and some fortunes lost. But unfortunately, as the administration keeps changing the rules, we really don't know who the winners and losers are yet, or will be."

KDP's Penniman, on the other hand, declared "we still like health care" - but with the caveat that "it's such a large, large sector - so it's pretty hard to make a generalization."

On the one hand, he notes that his investment advisory company scrutinized two health care service providers that were first-time loan market borrowers - "and we made the decision that we wouldn't touch them with a 10-foot pole," while some of the hospitals, on the other hand, are expected to benefit from the anticipated reductions in their considerable bad-debt expense.

"There are certain segments within the health care system that are definitely going to benefit, and then there are other sectors that one has to be careful of. I see some people say 'yes, health care is defensive and it's a good place to be,' and there are other people who see uncertainty. But when you look within the health care sector, there are a lot of different companies that make up that segment - and it comes back to individual credit selection."

What's hot - and what's not?

Apart from health care, Penniman said that "certain parts of the energy area are still attractive - although natural gas is not. We see a lot more value in the offshore drillers.

"The autos are doing very well." Some of the automotive suppliers "may be vulnerable to takeovers by private equity firms.

"The financial type companies in high yield, whether they are Ally or others like that, they're marching toward investment grade, because they're going to take advantage of the steeper yield curve.

"When you look at technology, it's still favorable.

"We like some of the retailers - but only those that have shown to date that they have good implementation capabilities. That would be Macy's, the higher-end stores, and maybe Dollar General at the lower end - but you'd really have to pick and choose."

A trader said that "the retail sector will be interesting. The energy sector will be interesting, based on my belief that both will be volatile, or more volatile than this year."

He also included health care, "because there's a certain amount of uncertainty."

With congressional mid-term elections and some governorships up for grabs, "broadcast and media will do a little better toward the end of the year, so people would want exposure to, really, broadcast there. I think there will be some further consolidation in the cable and the satellite industry."

On the downside, he said that "banks and finance will be a wild card - I'd be leery of some of the hybrids."

Another trader, who said that 2014 will be "a very uneven type of year - we're going to muddle through with the economy kind of improving, then falling back, then improving, then falling back - said investors will want credits "that will be dependable, with payments coming off of it, not swinging around a lot, that will do well. Cable companies and big hotel companies will continue to do well. Casinos are continuing to do well."

On the downside, "I would stay away from industrial credits - at some point in time, you are going to have some slack come back into the economy, so I doubt that they are going to continue to improve the way that they have in the last year."

Eschewing discussion of specific sectors, RBC's Cockrell said that there is "some logic to the investment strategy of taking on a bit more risk, at higher yields. If you believe that the most significant risk in the near term - which is a big IF - is going to be just [Fed] tapering, and that's going to increase underlying interest rates, then you must also feel pretty good about the economy - because tapering is probably only going to be sustainable for some period of time in 2014 if we have at least a decent economy.

"So, if you think we're going to have a decent economy in 2014 and the risk is that rates rise because of that, then I do believe that once again, the riskier situations are going to outperform as they are less sensitive to rises in underlying rates and they'll have the benefit of credit improvement in the improving economy."

He said that the CCC index, "is already yielding incredibly low compared to historical levels - it's at 8 7/8% right now, which is obviously very low - but to the extent that you can get riskier situations at attractive yields in those market conditions, they should outperform."

And he cautioned that at the end of the day, "in trying to predict the high-yield market, a day is a long time and a week is a lifetime - so the chances are whatever we are talking about today as the market drivers may not be what we will be talking about as the drivers 12 months from now."

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