Fallen angels could reshape the 2002 high yield market

By Paul A. Harris

St. Louis, Mo., Dec. 19 - They won't say exactly how many fallen angels they expect but some high-yield market observers anticipate that in 2002 investment grade credits will continue to cascade down into - and sometimes through - the high yield universe.

Indeed, the fallen angel factor could conceivably represent "supply pressure" in 2002 even as new issuance continues at an average pace, according to Walter McGuire of Deutsche Banc Alex Brown Global High Yield Strategy.

McGuire said that the $105-$110 billion in new issuance he anticipates in 2002 represents a relatively mild supply pressure on a historical basis. Compared to 1997, when new issuance represented 37% of the high-yield market, and 1998, when it comprised nearly 43%, 2002's anticipated $105-$110 billion should represent something much closer to the overall average since 1998 of approximately 19% of the market.

"What's going to give us more supply pressure next year is indeed the fallen angels," McGuire said.

The reason, he explained, is that the high-grade market has been the "hot spot" with investors. "They are the best performing asset class out there this year, despite huge amounts of new issuance - $600 billion or something. Last year I think it was like $450 billion. And there were good returns last year, too. As a result there has been a lot of rubber-stamping in that area."

McGuire suggests that one need only consult the newspaper headlines to see the effects of this rubber-stamping: some large, conspicuous companies with a lot of debt not fully understood by investors, now facing serious problems.

"It's not a wide-spread situation, but when those things come down to high yields - a market that's one-sixth the size of corporates - you're going to have some supply pressure."

Also anticipating supply pressure from a significant volume of fallen angels is Ali Balali, vice president of high yield credit analysis for Banc of America Securities.

However, in a recent report titled "High Yield Portfolio Strategy: A Year of Rebuilding," Balali and his colleagues at BofA advise that these credits represent a substantial opportunity for investors.

Balali said that for the purposes of the report, BofA measured its broad market index of 1,300 bonds. Then they measured former high-grade names in that index that lost their investment-grade status no more than 12 months ago. The numbers, Balali says, reveal that the fallen angels outperformed the overall index considerably.

"Through November 29, 2001, the fallen angels portion of our index had returned almost 27%," he said. "But the high yield market overall was up only 4.2%."

Balali said BofA is advising investors that there is "a big pipeline of fallen angels" coming during the first six months of 2002.

"They are going to change the shape of the market because the volume is so much," Balali said. "And they are usually coming in on the upper credit tiers, so the composition is going to change."

Balali said that in order to look at the likely volume that could come into high yield from high grade, BofA examined corporate bonds within certain ranges of ratings from Moody's and Standard & Poor's.

"We've looked at it at a very macro level," he said. "We looked at the mid BBB names, we looked at the weak BBB names, and we looked at the crossover names. And we selected crossover issues that had negative outlooks from either Moody's or S&P, and weak BBBs that had negative outlooks from either Moody's or S&P. For the mid BBB issues, we looked at bonds that had option-adjusted spreads of 500 basis points or more, and they had negative outlooks from at least one of these two agencies.

"And we basically summed up the total par amount outstanding. We identified 147 issues. And when we summed up the par at the end of October it was about $50 billion. So that was our way of scanning the universe, and seeing where the potential supply could come from.

"That doesn't account for the Enrons, or Dynegy, or Calpine, or any of those surprises."

Once you do factor in companies such as Enron and Calpine, Balali said the tally mounts rapidly.

"On May 31 of this year Calpine Corp. was part of our large cap index, and had a total market value associated with it of $4 billion," he said. "So if these guys are coming back into high yield, you have another $4 billion just like that.

"You sum up two or three of these guys, and there you go - you'll have up to $20 billion added that way."

Prescott Crocker, manager of the Evergreen High Yield Fund, also sees fallen angels as representing supply pressure in the high yield. However Crocker told Prospect News that the mutual funds tread very, very carefully with regard to fallen angels.

Crocker cited the Lipper High Yield fund median performance, which he said is up 2.39% for the year through Dec. 13, and said that obviously the mutual funds were not the beneficiaries of returns, the like of which are reported in the BofA index.

"I think there are going to be a lot of fallen angels," Crocker said. "Whether they are investable or not, I'm not sure.

"I'm also not sure that a fallen angel is in direct competition for the funds because it is an object in motion, as opposed to a traditional high yield issue which is theoretically a company in the process of improving itself - a management that thinks its equity is so good that they issue high-yield debt instead of equity, because their performance is improving.

"So that's a very different thing than a company that's under duress, whose traditional lending source is pulling out; a company that is crashing from one sector into another."

Crocker said he became intrigued by Enron when the bonds were trading in the 80s but declined to play.

"You reason that certainly the banks will keep them going," he said. "There's a lot of asset-value there. But it was all hocus-pocus.

"I've also bought Unisys, but very carefully.

"A fallen angel is something that has a high velocity of change," the Evergreen High Yield Fund manager added. "It's under duress.

"The best way to describe it, to me, is the metaphor of the 'falling knife'-syndrome: you have to be very careful when step beneath a falling knife."

End

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