Outlook 2013: Fed by the Fed, secondary market starred in 2012; solid sequel seen ahead

By Paul Deckelman

New York, Dec. 31 - In just a few weeks, everyone who is anyone in Hollywood will gather for their annual late-February ritual - the presentation of the Academy Awards for conspicuous achievement during the preceding year.

A key part of the time-honored ritual involves the winner of an Oscar delivering an acceptance speech, in which he or she publicly thanks anyone "who made all of this possible" - co-stars, directors, spouses or significant others, even Mom and Dad.

If Junkbondland were accepting an Oscar for Best Performance by a Financial Market in 2012 - having easily beaten out Treasuries and investment-grade corporates, while narrowly nosing out equities - probably the first "thank you" shout-out would go to Ben Bernanke.

Or the Federal Reserve chairman might qualify for his very own Oscar, for Best Actor in a Supporting Role.

Financial market people usually have a wide range of opinions on any given topic - but analysts, portfolio managers and high-yield traders surveyed by Prospect News were virtually unanimous in their agreement that the U.S. central bank's concerted efforts to aid the economy by keeping interest rates at historic lows were the key catalyst in the junk market's considerably better-than anticipated performance in 2012.

And they believe that with the Fed officially on record promising to keep those rates low, the same favorable conditions are in place for continued good performance in 2013 - although most acknowledge that with junk having come so far, its potential upside is limited. Returns, they say, should be respectable - especially versus other fixed-income asset classes - though likely less than those notched this past year.

Numbers tell the tale

As of Dec. 19, just days before the end of the 2012 trading year, the widely followed Merrill Lynch U.S. High Yield Master II index showed a year-to-date return of 15.553%, its peak level for the year. That was more than three times the 4.383% level at which the index had finished 2011, and even topped 2010's closing level of 15.19%.

Other components of the index, hovering at or near their peak levels for the year as December ended, showed similar year-over-year improvement.

The average price of a junk issue tracked by the index had soared to 104.521, up from 98.087 at year-end 2011. The index value was 951.716, versus 823.615. Its yield to worst had come in by more than 200 basis points, to 5.999% from 8.239%, while its spread to worst versus Treasuries tightened to 589 bps from 727 bps.

Other market measures told a similar tale. The Markit CDX North American High Yield index stood at 101¾ bid, 101 7/8 offered, after having begun the year at 93 9/16 bid, 93 11/16 offered, although it should be noted that the figures are not directly comparable, as index proprietor Markit rolls the index, or changes the issues it tracks, twice a year, in late March and late September.

KDP Investment Advisors Inc.'s High Yield Daily index closed on Dec. 19 at 75.32, after having begun the year with a 72.65 reading. It was yielding 5.69%, having tightened from 7.36%.

Fed moves feed returns

The founder and president of Montpelier Vt.,-based KDP, Kingman D. Penniman, told Prospect News that just before the start of 2012, his company had forecast that the junk market would likely return between 7% and 9% on the year, while adding that "we could see some significant capital appreciation potential - we just weren't sure what year we were going to get it in," 2012 or 2013. As it turns out, the roughly 5 points of average capital appreciation, on top of the coupon return, showed up in 2012.

The big question is why - and Penniman noted that "there was a lot of trepidation [in 2011] and everyone was looking at [just] a coupon - unless something extraordinary happened."

What happened was the monetary ease policy followed by the Fed and its counterpart on the other side of the Atlantic, the European Central Bank, as well as other major central banks of the world. The Fed - already having pushed interest rates down to new lows and pursuing generally accommodative policies - announced a big new round of quantitative easing in September, with the central bank aggressively buying as much as $40 billion of agency mortgage-backed securities a month to pump liquidity into the financial system and keep rates low.

"The ECB and then the Fed said 'we'll do whatever we can to make sure things are OK - we'll keep interest rates low, we will make the supply of high-quality paper scarce and you'll be forced to go into riskier assets, including high yield.' And that's what happened," Penniman said. "I don't think that anyone could have anticipated [ECB president Mario] Draghi and [Fed chairman Ben] Bernanke coming in so strongly and Bernanke continuing it in 2013."

An analyst at a brokerage firm opined that "when people are inside the high-yield market, they view risk and reward based upon what they are used to seeing, and I think the impact of the Fed's very low rates and the influx of monies into the market has caused a spike in returns - a much better performance, and I think you've got to thank the Fed for it."

While pushing interest rates down led to a paradigm shift in the kinds of yield offered to junk investors - new issues carrying previously unheard of coupons below 6%, 5% and in some cases, even 4% - it also helped "all the existing stuff, with 8%, 9% and 10% coupons, to perform exceedingly well," the source said.

"We were looking for coupon-plus, something around 10% at the start of the year, and we got more than that, which was a pleasant surprise," a junk trader at another shop said. "In hindsight, knowing what we know now about how aggressive the Fed has been, it's not surprising. [Junk] is the only asset class that really gets investors that need returns in that 5% to 8% area for their asset-liability matches, like the pension funds and the insurance companies. They're forced to buy high yield, and have been throughout the year, and are still huge participants."

At money manager Odeon Capital in New York, Mat Van Alstyne, the head of research, said that 2012 "has been a big surprise. My personal opinion is it goes to show that the Fed's plan is working.

"They're starving the market of things to buy, so the market is reacting by creating new products, creating new inventory. It's driving yields down, and for people who've been invested in high yield, making good returns for the calendar year, obviously.

"From our perspective, like everything else, we've been pleasantly surprised. 2012 has turned out to be a pretty good year."

Keep the ball rolling?

As to whether the junk market can continue its momentum, a trader predicted that "2013 is going to be pretty much steady as she goes. I don't see defaults rising. I see the U.S. economy showing some moderate to slightly improving growth as the year proceeds."

He allowed that it was very unlikely that the junk market will see the same kind of 15%-area yields seen in 2012.

Returns, he said "will be more in tune with the coupon rate, which given all of the refinancing," which has taken out a lot of the older, higher-coupon debt that was going to mature over the next several years, "is more in a 6% to 8% return for high-yield product. I think there's no easy money really left out there.

"But there are still people in need of income, and high yield generally fits the bill," as opposed to other fixed-income categories, such as Treasuries and high-grade corporates, that are returning far less.

The brokerage-firm analyst agreed that "yeah, there will be a couple of hiccups, because there always are - but there's nowhere else for people to put their money, if Treasury rates are zero, out several years. Then high-grade rates trade on a spread off of that and the only place where you can get any yield is in our market - even if it seems tiny compared with historical yields."

Another trader projected that "as far as yield levels are concerned, I don't really see anything changing. I think there's going to be tremendous demand for any kind of yield. You might have these pullbacks when the economy looks like it's particularly weak. I don't think the Fed will do anything [different] next year [in 2013] - it's going to be more of the same, trying to get the economy going.

"The Fed is going to continue to try and pump this thing up."

Over a cliff?

The path to getting a decent return in the coming year is not without its obstacles - chief among them the prolonged Kabuki dance going on in Washington between the White House and Congressional Republicans over the looming "fiscal cliff" - the possible expiration on Jan. 1 of broad-based tax cuts if an agreement on their extension cannot be reached, combined with the threatened imposition of severe cuts to the defense budget and Medicare absent an agreement on deficit reduction.

The prospect of those events cast a pall of uncertainty over the fixed-income, equity and other financial markets during the final months of 2012 and had not yet been definitively solved heading into late December.

Against that backdrop, the first trader said that for the junk market to be able to generate decent returns in the coming year, "obviously, we need to get rid of some of the dysfunction in Washington, D.C. That's probably the biggest holdback in the market right this second, as your other technicals in terms of performance - spreads and defaults - are flashing a green light."

Odeon Capital's Van Alstyne - who believes that a 7% or 8% gain in the coming year would be "a great return" - said that short-term uncertainty over resolution of the "fiscal cliff" is "definitely priced in, but ultimately, it's going to be resolved."

He suggested that "the market would react very positively to a longer duration of resolution. A one-year deal or a two-year deal or a three-year deal or a four-year deal, or any sort of short-term deal - won't get nearly the positive reaction that a permanent [solution], or something that's seemingly permanent, or a 10-year type deal would get, regardless of the nuances or details of the deal."

But apart from "fiscal cliff" - related angst, "it certainly seems like we're in for a continued positive market, and continued Fed intervention will be the assurance of that."

He explained that the Fed's plan of action "creates the absence of inventory - when you have the Fed pulling out dozens of billions of dollars of inventory per month, regardless of what inventory it is, it has a cascading effect into other asset classes. It's the type of purchasing that raises the valuation of all asset prices, because the scarcity of product causes the increase in price of what is scarce. It feels like what we're short of is coupon-paying paper - certainly coupon-paying paper at any level. So that means the price of coupon-paying paper is going to rise."

He added that "if the Fed were to change its tune, they have to come off the gas pedal at a moderate pace, just to make sure they don't cause more harm unwinding than good. But they've been pretty clear - they're keeping this going for at least the next couple of years, and as long as they follow through, I think the market is going to react positively to that."

Yield hunger to drive returns

A trader noted that in 2012, high yield "had a great run, strengthening across the board from as low as your CC and CCC paper, all the way to your BB type paper. So there was a real grab for yield, when you look back at 2012. So if you knew then what you know now, even gobbling up stuff that was a heck of a lot more risky, it fared very well."

Coming into the new year, he said, "one of the concerns from a trading standpoint is how much liquidity are we going to have? How tight can they continue to bring that paper? Even though we have money chasing a lot of these issues, you're getting to the point where a lot of the sellside guys are almost sideways [on 2013]. They think it's going to be a great year, but at the same time, they're telling people 'you can't look to purchase every single thing and think it's all going to go up.' So you need to do your homework."

That having been said, he predicted that "you'll definitely have opportunities where you're going to see tremendous tightening. You're going to continue to see spreads tighten and you're going to continue to see lesser-quality paper really do much better than it should, based on the fact that you're going to have this grouping of people that don't want 3% on the [Treasury long] bond, or 1¾% on the 10-year. They want yield - and if you look at what's out there and you pick and choose, there's still stuff out there can yield 7%, 8% 9% - or even 10%, 11% 12%. It's still there."

He said that "if we're talking about clipping the coupon - and if you're holding something with a 10% or 11% coupon, and if that thing continues to chug along, well, guess what? You've got 10% or 11%.

"I think you're still going to have strong returns next year. I think with the lack of supply - they're saying supply is going to be a little limited next year or reduced - and people clipping the coupons, and some of them are big coupons, I don't see why you don't do double digits. Everyone says 'it's the top' of the market, but you know what? We continue to grind higher."

With much of the new paper being sold in the junk market carrying what in the past would have been considered impossibly small coupons for a high-yield deal - for instance, Ally Financial Inc.'s $500 million offering of 3 1/8% notes due 2016, which priced on Nov. 28, or DISH DBS Corp.'s $1.5 billion of 5% notes due 2023, which came to market on Dec. 19 - the trader acknowledged that a portfolio heavy with such new deals won't produce much of a return.

"With a yield of 4%, can we gain 15%? No. We can't do that. But there's still stuff out there that has room to grow. There's still distressed paper out there. There's still high yield that's CCC-type paper that's in the 90s or in the 80s, with 10%, or 11% or 12% coupons. If that sector continues to explode and ride the wave with better-quality stuff? Yeah, you could see double-digits. Absolutely."

A more bearish view

Not everyone in the junk world necessarily goes along with such a bullish scenario.

Another trader observed that with the ever-smaller coupons and yields on the new deals, "some of the more traditional high yield, or value players, have sort of stepped to the side as it's gotten kind of lofty, or rich, and you've got more of these crossover buyers that are reaching for yield, starving for yield, even, and they keep flooding the market with money that has to be put to work." Traditional junk accounts are shunning some of the deals, he said, because "earning 4% for the next 10 years isn't their mandate."

He said that among the new bonds, "everything is being priced to perfection right now - and what happens when that perfection goes away? How far down are these things going to trade?"

Although the crossover junk paper may look pretty good to high-grade players right now, "the interesting thing will be when do all of these crossover/high grade guys run for the exit? Who's going to get there first, and then, how bad is that bottleneck going to be, when those types of accounts or buyers decide that they need to exit this asset class?"

If an investor is earning 4% or 5% on one of those lower-coupon new issues "and the thing drops 10 or 15 points - which we've seen over the last couple of years that can happen in the course of a few days - it's not a good current-income play. You might say 'great, we're earning 5% on the coupon - but we just lost 12% on the principal.' I think when we had that flash-crash a year and a half or two years ago, there was a period of a couple of days where [issues] didn't just come in - they slid in."

He declined to forecast that "the bottom will drop out, like it did three or four years ago - but one day, everyone's going to go in and say 'holy crud' - and there's the sell-off. And it's that kind of sheep mentality. You have a few of the large guys start that and everybody else follows.. . . it will be one of these things where you won't see it coming and it'll just happen and everyone will be sitting there [asking themselves] 'why were we in this asset class for so long'?"

Against that cheerful backdrop, the trader - who had predicted a 2012 return of around 9% to 10% - warned that 2013 returns could go as low as unchanged to down 3%. "If the 10-year Treasury backs up by 100 bps, take a 10-year bond that's got a 6% coupon, you're going to lose that coupon - so that's why I'm thinking that it's flat or down a little bit from there. I'm going out on a ledge on this - boldly going where no one else has gone."

Coupon consensus

But most of those surveyed fell somewhere between the extreme outliers of double-digits on the upside and a 3% loss on the downside, instead seeing investors getting their coupon, meaning probable returns in the mid-single-digit area.

KDP's Penniman, for instance, believes that "the high-yield market is now a carry market," with investors likely to earn a 5% to 7% carry-trade return. He said that there likely won't be any capital appreciation, since junk already got that in 2012. "Yields are at historically low levels. Spreads still compensate you for default risk and compensate you for the type of interest-rate risk we'll see this year, depending on the extent of economic activity."

The average junk return "is not going to be the type of equity-type returns [seen in recent years], unless equity is low - it's going to be a fixed-income instrument, but as a fixed income instrument and being compensated for default loss rates or risk, and some volatility, it's still going to be very attractive to a lot of people. But you can't expect capital appreciation."

What's hot - and what's not

Looking at specific areas where junk investors might be putting their dollars for maximum returns in the upcoming year, Penniman declared that "obviously, health care is now perceived as a defensive industry, with low volatility, depending on what's happening on a regulatory basis, and there are some areas that are very attractive.

"It is defensive, it always has been, but since the election, it's even more so."

Another sector he likes is energy exploration and production, particularly on the chance that some higher-rated, cash laden companies will acquire junk energy names - for example, the way Freeport McMoRan Copper & Gold Inc. announced in early December that it will acquire a pair of high-yield energy players - Plains Exploration & Production Co. and McMoRan Exploration Co.

"I think E&P in the energy area continues to be attractive, with Plains, and with Chesapeake [Energy Corp.] announcing an asset-sale, so they got part of their [asset monetization] program done more quickly than expected, which is good news. There you have M&A, acquisition attraction."

KDP is also positive on auto parts and equipment manufacturers. A number of those companies restructured their balance sheets via Chapter 11 in recent years and now "they're solid credits, and they're starting to participate, and don't have a lot of European exposure. That's an attractive area."

Penniman said that "wireless and telecom continues to be an area that we would think in this kind of environment is attractive, as they are integrated services," and is also constructive on the cable sector.

On the downside, he said, with the prospects for a continued sluggish U.S. economy, "I have an overall reluctance for some of the consumer companies, certainly some of the retail and food companies, and some of the commodity-like companies that are potentially built for an economic revival of level that certainly isn't coming to pass."

He also singled out "those that depend on China - the metals and mining and steel - have come under a lot of pressure. They continue to indicate that their numbers next year are likely to be worse, so you are having an effect."

But while cool to the consumer-driven part of the market as a whole in the face of the weak American economy, he surprisingly likes gaming, even though it is dependent on consumer discretionary spending.

"You've got both what's happening here in the U.S. and what's happening in Asia and other parts of the world that's offsetting that, but I think that when we look at where the numbers are, a lot of those gaming companies have become, or are trying to become, destination resorts for the families, as opposed to just the serious gaming person, so we are talking about Las Vegas and the Gulf Coast, and where they're more family-oriented. And we haven't seen any indication that they [customers] have pulled back, necessarily," he said.

'They've learned their lessons'

A trader said that in his view, "the industrials are fine, and the techs." And he urged investors that instead of parking excess cash in money-market instruments, "I would look for yield-to-call paper, which I am sure is almost definitely going to be refinanced. I would definitely do that instead of money markets."

Energy, he said, "is always going to be a decent space, as long as the companies aren't too leveraged, so I think that could do well."

He thought that cyclical industrial credits, such as steel companies and automakers, might be more problematic, since such companies "are going to be affected [by the expected weak economy] to a certain extent - but they know that. That's why they're cutting back and really cutting their costs. Let's say they've been given enough of a warning. They're going to struggle - but they know what they're facing."

For instance, he said that AK Steel Corp. "even though they still have a shortage of certain cash, they bit the bullet and did another financing, which helped them tremendously. In other words, where all of these companies used to always feel that they could refinance forever, they're now in the real world." He said that such companies had already anticipated that the economy would be weak and earnings lean, so they have been cutting headcount, closing facilities and otherwise cutting out a lot of the fat, so they should be able to weather the hard times. "That's the feeling out there."

While some of those surveyed were positive on health care - especially given the role that coming changes in the health care laws are expected to have in reducing hospitals' bad debt expenses by extending health coverage to the indigent - this trader was cautious, given the unanticipated effects that heavy governmental regulation might have on companies.

He was also reluctant on financial companies, due to the difficulty in assessing the true value of securities carried on their books. "Anything that you can't read a balance sheet and do an [analysis] on, or that's too dependent upon regulation, you have to be careful. Anybody that can carry a ton of bonds, and nobody knows where the real market is, you just have to be a little cautious.

"You want to smatter your portfolio with some of them to diversify, but for conservative people, I would stay away."

Among the consumer-oriented sectors, he said that homebuilders "have learned their lesson, and I think they're doing very well - the builders and even some of the retailers. The retailers are now inventory-conscious - they really are. So I think they'll continue to mull along there. And the homebuilders know to cut out the speculative building now - they're almost selling before they start manufacturing.

"A lot of people have learned their lesson the hard way in here, so I don't think you'll see the sloppiness that anything can come to market and sell out. It's not that way anymore."

Obamacare a wild card

With much attention in the general and financial media directed at the coming impact of the Patient Protection and Affordable Care Act, popularly known as Obamacare, Odeon Capital's Van Alstyne said that "I'm not so sure that really changes anything - I think Obamacare affects the macro economy a lot more than specific sectors, case by case."

He said that his shop is "actually pretty optimistic that any impact from Obamacare or these types of structural changes have already been reflected in consumer spending. I think the bigger question is going to be what it does to businesses and how they impact the employees and shift how health care is paid for. Broadly speaking, it's not really a 2013 event, it's more of a 2014 event for consumers and businesses - they have to make a decision on how they pay for their health care, what plans they provide, whether they're going to pay the penalties or not."

However, there are still many questions about the massive law and its impact, intended or otherwise. "We're still sitting here at this point in time not knowing which states are signing up for the federally controlled or state controlled exchanges, and how those are going to be paid for. I think there are a lot of unknowns, that, given that we're looking at 2014, as when it really goes into effect that we'll start seeing clarity in 2013 as to which direction it's headed. I certainly think that if policymakers make bad decisions, hopefully, they'll have time to correct them before the impact is felt, just seeing the market's reaction to a bad policy decision."

Away from health care, the Odeon research chief likes "traditionally cash-flowing, coupon-paying investments, where you get return of your principal on a regular steady basis, which is why we're involved in high yield."

He said that "longer duration is the riskiest place to be if the market takes a turn - and so you would want to have a balanced portfolio. You don't want to be all long-dated and you certainly don't want to be all short-dated, because you aren't necessarily getting the same kind of yield. So I would think if you're going to re-flex your portfolio, you're going to change it to one with a more defensive posture - that would be more balanced on middle duration - have some short duration and some long duration - and also stay in the sweet spot in the middle of the credit."

No disaster for defense

Despite planned defense cuts from the Obama administration, plus the prospect of additional cuts under the sequestration agreed to by a congressional "super committee," absent any meaningful deficit reduction progress, a trader said that high-yield aerospace and defense companies likely won't be much affected.

"It's probably already priced in and most of these companies have already made their arrangements to weather the storm," he said, "so I think the cat is already out of the bag as far as that being a surprise."

He also noted the impact of continued Middle East tensions, which have the potential of increasing sales for such companies.

The trader also sees health care and related companies "just going to continue to thrive. I don't really see any slowdown there at all. With these government programs kicking in, you're going to have continued employment gains and those companies are going to have an underlying good tone."

On the other hand, he said, "there are some of these questionable companies in the coal area. I think [the government] will just get tougher on these restrictions and make it tougher for these people to do what they need to do." He also expressed caution on steel and natural resources.

A contrarian on coal

Another trader disagrees when it comes to coal, noting that "this is a sector where everybody said 'I won't touch it.' I think people are crazy not buying it."

Coal, he said "is cheap, even though it has rallied dramatically in the last [several] weeks. You have Walter Energy Corp. up 10 points; you've got Arch Coal Inc. up 8 points."

Coal is not popular in some quarters, due to nervousness about government efforts to curb coal use - a market source at another shop bluntly said that "Washington is trying to legislate them out of business" - but the trader said that "that's why investors have five to 10 analysts on their staff - to dive into sectors that are out of favor. If all you're trying to do is buy the sector that everybody loves, you're never going to get an allocation and you're never going to build a position at a reasonable price. But if you go to a sector that may have had some negative news, and if it's not fatal to the companies within that sector, yet everybody holds their nose and runs away for a while, it presents a tremendous opportunity."

And he wasn't just talking about coal, noting that "it doesn't matter whether it's telecom, or minerals and mining, or chemicals or homebuilders or building products - I think some of the best returns this year have probably come from building products and coal - just buying the names that people hated at the beginning of the year, or because at some point during the year, there was an event that caused a dislocation, prices widened out and then the sector became oversold. But not every company in that sector is going to go bankrupt."

He also said that favored companies and sectors weren't always what they were cracked up to be. For instance, "there are many companies in the energy space that may be overvalued right now - but they're bid up because everybody wants to own energy.

"And then you have companies like HCA Corp. and so on that are huge cash-flow generators. Yet, those companies are going to stay highly leveraged, as the equity sponsors continue to take money out of those businesses" - the planned use of proceeds for HCA's $1 billion bond deal in early December. "They're not expanding the business, they're not growing it; they're paying themselves."

He further said that investors could profit by buying smaller deals - $150 million or $200 million - in good companies that many market players shun for lack of size and potential lack of liquidity. "Everybody assumes that a small deal is going to go bad - that's the fault in their logic. If people didn't buy small deals, you wouldn't have venture capital." And, he said, even big deals sometime turn out to be a "roach motel" that investors can get into but can't get out of. "Look at TXU - that's the biggest and supposedly most liquid deal out there, and if you want to sell a block of that - forget it."

He predicted that "if we get a 7% return this year, that will be pretty good - that will be a banner year. I think the way you get there is buying off-the-run high-coupon debt, buying high-coupon yield-to-call debt and playing the calendar for fun and profit - going where other people don't want to be."

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