2001 is gone - finally. Now let's get on with 2002

By Paul Deckelman

New York, Dec. 31 - If somebody had told you at the beginning of 2001 that by year's end, America would be at war with a backward nation half a world away, the World Trade Center would be just a memory, a Republican not named Giuliani would be elected mayor of heavily Democratic New York, troubled Pacific Gas & Electric's bonds would be trading around par and mighty Enron's notes would be worth less than 20 cents on the dollar, you would probably have told him he was crazy.

It's been that kind of a year, what one trader called "a real roller-coaster ride."

The high yield market, after suffering through two years of credit and liquidity crunches, seemed poised to finally break out of its rut, with major junk bond market indexes, a measure of performance, and mutual fund inflows, a measure of liquidity, starting strong over the first couple of months.

Then, the trader said, "you watched the economy slow down as you got to the middle of the year and with recession looming, you saw junk bonds started to slow even more as the default rate began to increase, and that put our market into a standstill for a little while. Then the events of Sept. 11 really curtailed what we were doing."

The twin attacks on the Twin Towers and Washington D.C. slammed the brakes on whatever kind of momentum the junk bond market (as well as the equity markets) had built up. High yield new-issuance went into the deep freeze, and the secondary market plummeted, particularly such travel-sensitive sectors as airlines, shipping (most cruise line companies depend on travelers coming to their port of departure by air), hotels, gaming and other leisure pursuit. It was not until early October that junk market players felt it safe to stick their heads out of their foxholes.

Over the next two months, though, they made up for lost time, and lost ground. The primary sector saw dozens of offerings price to meet the pent-up demand for new paper, many of them quickly shopped "drive-by" deals taking advantage of favorable borrowing conditions, and some of them upsized from original levels to meet hefty investor demand for the paper. The cavalcade of new issues culminated with a $700 million offering of senior notes brought by satellite broadcaster Echostar DBS on Dec. 20.

In the secondary trading sphere, major market performance indexes went on a two-month winning streak, which finally came to an end in early-to-mid December, when they pulled back somewhat from their recent highs under the pressure of end-of-year tax-loss and portfolio clean-up selling. The Banc of America High Yield Large Cap Index, which tracks almost 350 issues of $300 million or over, showed a cumulative year-to-date loss of 2.80% in the week ended Dec. 20 (B of A's last report for the year) - still considerably improved from the near-double-digit deficit it had shown in the weeks immediately after Sept. 11. The broader Bear Stearns High Yield Index, which tracks over 1,400 issues ended the year, or at least the year to Dec. 27, with a cumulative return of 5.22%.

Those index improvements went hand-in-glove with improved market liquidity, as measured by the weekly AMG Data Services mutual fund-flow numbers. According to market participants who follow the weekly statistics, some 1.6 billion had hemorrhaged from the market in the five weeks immediately following Sept. 11, but in the next nine weeks over $2.6 billion more came into the funds then left them. In the last two weeks of the year - again no doubt reflecting portfolio adjustments and other year-end phenomena - about $673 million flowed out of the funds, most of that in a $653.3 million outflow in the week end Dec. 19. But with mutual fund flows having shown a strongly positive trend for the year as a whole prior to Sept. 11, the year-end totals were encouraging, as inflows were recorded in 36 weeks out of 52. The assets of the funds tracked by AMG increased to $67.1 billion from $48.3 billion at the end of 2000, including price changes and interest payments.

September 11 certainly "dealt a setback" to a market which had been well on the mend up to that point, said Merrill Lynch & Co.'s chief global high yield strategist, Martin Fridson. But, he added, "despite that, we have not seen an escalation of default rates [since then] on a month-to-month basis." The attack and the resulting financial market turmoil "was something that couldn't have been foreseen or avoided, but the market has rebounded dramatically from that point."

Merrill Lynch's data showed that "the high yield market was very much undervalued at the end of September. Either investors agreed with us or they came to the conclusion on their own that it was a good value. Of course, good things happened on the political/global front that facilitated the return of capital to both the high yield market and the stock market. Given what happened, it could have been a lot worse."

A trader called 2001 "the year of the fallen angel," as investment grade credits "fell very quickly into distressed and high yield accounts. Instead of the one- or two-notch downgrade after two months or three months or a quarter of bad news or bad numbers, they're just cutting ratings four or five notches."

The trader said the proliferation of high-grade credits which suddenly move into junk-bond land creates "a lot of opportunities" for savvy market players who take the advice of legendary country and western singer Kenny Rogers, who said that gamblers (like junk bond players) "gotta know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run."

Analyst Ron Gies of Stone & Youngberg LLC in San Francisco would agree that in 2001 "there was a lot of money made on fallen angels and other credits as a result of illiquidity and sloppiness. People didn't really know how to trade them when they came out. Those kind of opportunities will be there in the first quarter (of 2002) and the second-quarter as well."

Gies believes that the previous investment community consensus which expects a second- half recovery "is starting to wane. The fourth quarter 2001 and first-quarter 2002 results are going to send more fallen angels our way. I think that's going to contribute to more market sloppiness" - and to more opportunity to those who know how to take advantage of it.

From his post in The City By The Bay, Gies had virtually a ringside seat on the trials and tribulations of the San Francisco-based Pacific Gas & Electric Co., which a year ago was desperately hoping for some kind of state action to help it stave off looming bankruptcy. The villains, in the utility's view, were out-of-state energy traders who it claimed were selling it electricity at unconscionably high wholesale prices - prices which it could not recover from its customers under the Golden State's partial deregulation scheme. Chief among the black hats, in PacGas's view was, of course, Enron Corp.

Gies notes with some irony that "PG&E was sitting there with a viable, solvent entity, claiming to be the weak sister and pointing fingers at the company that was truly insolvent." Both companies eventually filed for Chapter 11 - Pacific Gas in April and Enron in December.

"The day PG&E filed, it was clear that they were a solvent entity with more assets than liabilities. That was a political filing, and the fact that they were pointing fingers at the soon-to-be insolvent Enron was just part of that politics," the Stone & Youngberg analyst added.

While the utility has since made great progress towards restructuring itself without costing its bondholders a dime - its secured paper currently trades "at par, plus or minus," he points out - Enron is currently in the process of selling assets, including its core energy trading operation, and its bonds are quoted below 20 cents on the dollar, showing some of the weird bounces the ball can take in the world of business.

The Enron debacle was astonishing for the sheer speed with which the once-powerful Houston company fell from the ranks of investment-grade respectability all the way down into the realm of distressed debt.

But even that fall, big as it was, pales next to the meltdown of much of the telecommunications sector in 2001, with one telecommer in four in default or even bankruptcy by year-end, including such former high fliers as PSINet, Winstar, and Exodus Communications. Other telecom operators like Level 3 and RCN were shedding their burdensome debt loads without going into bankruptcy, by tendering for it at a discount or swapping it for equity.

"If there are 20 telecom companies out there now, by this time next year there will be 10," a trader said. "Whether it's going to be by consolidation, which I think is going to happen even more so, or whether some high fliers are just going to go away just completely and go out of business, unless a white knight steps in."

Gies of Stone & Youngberg points out that "all of the bank lenders to all of those companies overlap. At some point those banks are going to decide publicly or privately which of the telecom companies will survive. Because of their overlapping investments, they're going to pick which ones are going to survive in a market with fewer competitors, and it will be an interesting process to see play out - because it's clear they're not all going to survive."

Another trader opines that "even telecom names that have been really beat up and have been burning money really fast still have a structure. Global Crossing still has an infrastructure, Level 3 has an infrastructure - it just depends what they do with it. So there are definitely some shots to be taken there - but it's not for the faint of heart, that's for sure."

The trader sees some slightly less nerve-wracking opportunities in the travel and leisure names - "your Host Marriotts and Extended Stays, which have been beaten down pretty bad. If they can hold stable and show some increase in people traveling or people staying in hotels or people spending money, I think they're undervalued right now and going forward, they should move ahead."

Also on his shopping list for the high yield investor in 2002 is the retail sector: "Kmart has a name, and you look at the Gap Stores, and Dillard Department Stores. If you have a turnaround and people spend more money, those companies will be in a position to do a little bit better."

Companies in all of those sectors "have been beaten so badly that unless they go out of business, I don't know how much lower they can go. Some of the yields you're looking at are just mind-boggling. So you're definitely going to see a tightening in some of these sectors - travel, retail and even energy names that are quasi-related to the asbestos problem or the energy crisis in the U.S., I think you can see a bounce there also." He notes that AES Corp. paper, which, along with Calpine Corp. fell back 10 points or so in the wake of the Enron fiasco, has since come back. "All of the problems they were having, and look how they bounced."

Another trader also gives a vote of confidence to the retailers, saying that the merchants "have gotten decimated this year - there's probably a lot of value in some of the better ones right now, as we rebound going into the second or third quarter of 2002."

Even though winter has so far not packed too much of a punch - except in Buffalo - and the Organization of Petroleum Exporting Countries has struggled to come up with a plan to cut crude production, he likes oil and gas issues, "based on what crack spreads are and what have you (crack spreads are the difference between the cost of a barrel of crude oil and the value of the refined products, such as gasoline and heating oil, produced from it). The oil and gas companies look pretty cheap - maybe not cheap - but probably look like a good area to get into, even going into a warm winter."

One other comeback candidate, he says is technology. "As a whole, I can't imagine it getting any worse than it was this year. It's probably a good time to step in. I'm talking about computer and technology companies that have hard assets, tangible assets."

"Crossovers will continue to be hot," says one trader who specializes in that particular genre. Noting that major companies such as Deutsche Bank and Motorola are still announcing significant layoffs, he warns that "I personally don't think the economy will be turning around as quickly as people think." In such an environment, "there's going to be more of a focus on fallen angels."

On the other end of the credit spectrum from the soon-to-be junkers, he says, the badly beaten telecom issues "will continue to be the focus. It will be interesting to see what tack they take in their restructuring - because it seems like everyone and his brother is doing that now.

"We'll just hope for some volatility, because everybody can make some money when it's volatile."

Merrill Lynch's Fridson says the Big Bull usually recommends buying sectors which have a preponderance of improving credits, based on the ratings outlooks published by Standard & Poor's, since historically such industries have generally outperformed the overall junk market. "Unfortunately ,there's no industry in that category at the moment," he notes.

The next best thing is to speculate about possible turnarounds for industries "that are so far beaten down that their spreads versus the (Merrill Lynch) high yield index are extremes." Fridson says industries in that category are airlines, insurance, metals and mining, cables (mostly because of the deterioration among European operators), non-air and non-rail transportation, telecom and textiles.

A trader, taking a longer-term view, philosophizes that "things go in cycles - and you know, you can't have a world class economy where things go up for 10 years without giving something back. I think we'll get out of it - but the days of buying anything and having it go up 20% or 30% in a quarter or two are over." 2002's investors, he predicts, after seeing the volatility and market reversals in 2001, "will be a little be more wiser, a little more leery about jumping on any bandwagons."

End

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