High yield secondary surprised in 2003; moderate but respectable returns seen for 2004

By Paul Deckelman

New York, Jan. 1 - If 2002 was the much-lamented "Year of the Blow-Up," with former seemingly solid credits blowing up left and right and tumbling sharply, many into default and subsequently bankruptcy, then 2003 was surely the Year of the Run-Up. The high-yield market, with the wind already at its back from a liquidity revival that started in the 2002 fourth quarter, grabbed the ball, started running - and never looked back. By the end of the year, the junk market had posted astonishing cumulative returns approaching 30%, according to indexes published by several major brokerage houses.

Can high yield continued to put points on the scoreboard in 2004 at such a torrid pace?

The general consensus among analysts and market participants queried by Prospect News is probably not. But most feel that junk bonds will certainly still provide a very respectable return.

Looking for a good year

"There's no question that [2004] is going to be a very good year for high yield," said Kingman D. Penniman, the president of KDP Investment Advisors Inc. of Montpelier, Vt.

"It's going to be competitive again, obviously to other traditional fixed income, but definitely very, very positive relative to that, because the spread is what's going to protect any principal erosion as a result of rising interest rates. That will give you good, healthy, positive returns and may be compatible with equity projections" for 2004.

Certainly, Penniman flatly asserts that there's "no way" that the junk market will be able to duplicate this past year's truly stellar returns in the 28%-30% range. "It's going to come down significantly," he projects, saying investors will be "very happy" to get a return in the high single-digits or the low double digits.

Penniman noted that a good part of the return this past year came from capital appreciation as opposed to income - maybe as much as 60% to 70%, depending on how a particular portfolio was structured - adding that "if you look at any history of the high-yield market over a cycle, all of the return has come from income - in fact, principal has a negative factor to total return.

"I think that the market has come back [from 2002's doldrums], and has snapped back so quickly that in a lot of cases there's not much room for further capital appreciation, which is why I think the 2004 focus is going to be more on principal preservation - earn the coupon and pick those credits with potential for upgrades or tendering where you can get a couple of points of positive event risk as companies are going to take advantage of the liquidity in the market to refinance. That means a lot of bonds that are out there are being called and tendered."

Beware: rising interest rates

Strategists at Banc of America Securities laid out a base case 2004 scenario in their recently published year-end research report that assumes that rising interest rates will likely be offset by tightening credit spreads.

"The result is a coupon-clipper for high yield, with total returns centered on today's yield level of 8%," the B of A analysts wrote. With the economy expected to continue on its positive course and the recent trend of an overall improving credit environment in the high-yield universe also seen continuing [see separate report on declining default rates elsewhere in this issue], they see the major threat to the market's current equilibrium coming from a possible sharper-than-expected rise in interest rates.

Although B of A projects that interest rates likely won't start rising notably until the second half of the year, as the Federal Reserve starts tightening up at or after its summer FOMC meetings, the bank's analysts acknowledge that should interest rate risk start rising faster than anticipated, a "much lower" total return than the forecasted 8% area could result.

The report points out the market's Catch 22: issues with the lowest credit risk (i.e. the most financially healthy and stable) are the most vulnerable to rising interest rates, while credits "with room for more spread compression as economic growth strengthens cash flows and credit quality" - in other words, those laggards still trading at sizable spreads over Treasuries due to more troublesome financial and credit characteristics - are less likely to be impacted by rising rates and "should outperform."

Thinking highly of lower-rated names

Accordingly, "at this point in the credit cycle, with credit quality still improving and modest room for further compression in credit spreads, we continue to recommend a down-in-quality portfolio strategy," B of A said.

Indeed, among the more than 20 issues which the B of A report rated as its top picks as of early December, were such names as bankrupt Adelphia Communications Corp. and its Century Communications subsidiary, and the defaulted 8.8% senior notes due 2003 of Amerco Inc., also currently in Chapter 11. Other lower quality selections on the Top Picks list of best investment ideas include Charter Communications Inc. (Ca/CCC+), Denny's Corp. (Caa2/CCC-), Dynegy Holdings Inc. (senior unsecured notes at Caa2/CCC+), Levi Strauss & Co. (bank debt at Caa2/B or B-), Paxson Communications (Caa1/CCC+) and Aquila Corp. (Caa1/B).

"Among most of the solid high yield credits - the BB paper and even some of the single-B paper - I think a lot of the life has been squeezed out of them," a trader said as he noted the tendency of high-yield investors to start gravitating toward lower-quality names.

"I think investors are going to start going down the credit spectrum - we've already started to see it with some of the new issues coming at the end of the year, the CCC stuff. They're going to go down the spectrum - CCC, CC, looking for yield, if the market continues like this."

Higher quality junk, he said, "is at such high multiples that it's impossible to buy it at these levels, and no one has the paper [for sale]. So I think people are going to extend out, take more risk and hopefully have more upside potential because of the credit quality, where it's a Trump [Hotels & Casino Resorts Inc.] or it's a Calpine [Corp.]."

He noted of the latter company that investors "have been really riding those up lately, up three points last week - and those are CCC rated." The Calpine 8¾% senior notes due 2013 were recently quoted - CCC rating and all - at 97 bid.

Trader warns: take it slowly

Another trader said that he was approaching the new year "with the caution flag up," because in his opinion, "a lot of these bonds have gotten ahead of themselves and they're trading at levels they shouldn't be, except that there's too much cash chasing too few bonds."

There certainly is no shortage of cash in the market to continue fueling both the primary market new-issues surge and the secondary market rally as the new year gets under way - AMG Data Services, whose weekly junk market mutual fund flow numbers are a closely watched gauge of overall high yield liquidity trends, reported yet another inflow, of $206.3 million, in the holiday-shortened week ended December 23, the most recent week for which the figures are available.

According to a Prospect News analysis of the data, it was the eighth consecutive week in which more money came into the junk funds than left them, the 13th in the last 14th, and the 35th out of 51 weeks for the year as of that date. The cumulative year-to-date inflow as of that time had ballooned to about $20.034 billion, according to the analysis, including only those funds reporting on a weekly basis and excluding distributions.

And mutual funds, while regarded as a steady and reliable measure of the broader liquidity trends, only account for a relatively small portion of money being invested in a high yield universe estimated by some accounts to be over $700 billion.

KDP's Penniman noted that besides all of the money coming into the mutual funds for investment in junk, "we've seen a lot of money from pension funds, insurance companies and endowments coming into high yield. I think those flows coming into the market are going to continue into the new year."

With the market floating on its comfortable cushion of easy liquidity, the second trader said: "I think we're getting sloppy again in terms of credit quality. And I see a lot of bonds are trading well ahead of where they should be trading, when you see single-B paper trading with a 6-handle" in terms of yields.

The market, he said, "is like a runaway freight train" dragging the prices on everything north, "and you don't want to step in front of it. Even a lot of the portfolio managers that I've talked to don't believe in some of the paper they're buying - they really don't want to buy it, but they don't have a choice because the cash keeps coming in to them.

"I've put the caution flag up because things just don't keep going up automatically." He noted the Parmalat Finanziaria SpA debacle that exploded just as the year was ending, with the Italian dairy products giant's formerly solidly investment-grade bonds beaten down to levels under 20 cents on the dollar and the company itself driven into bankruptcy by revelations of some decidedly fishy Enron-type dealings - shades of 2002!

"There are still some landmines out there," he added.

Steel industry: back from the dead

But most observers were certainly more hopeful. Typical is George Kirchwey, high yield analyst for Samco Capital Markets in New York, who noted the hefty gains seen in 2003 and opined that "I think high yield for 2004 is also going to be strong- I think the recovering economic climate will encourage new issuance of high-yield bonds and will also help the recovery of some of the lagging sectors."

One such sector was the steel industry, whose bonds had lagged far behind the rest of the market for most of the year, but then caught fire in early December, handily outperforming other industry groups in the last month of 2003.

The steelers "demonstrated very surprising strength and recovery in the last several weeks. I think that's going to be the story in the early part of 2004 as well," Kirchwey said.

"The industry had been given up for dead, and the news on Dec. 4 that the Bush administration was dropping the protectionist tariffs on many foreign -made steel products - I think many people took that to mean 'OK, that's another nail in the coffin of American steel' - but there's a number of countervailing factors going on that mean the repeal of the tariffs is kind of a non-event."

Among those other factors which count more than the tariffs, he said, were the weaker American dollar - down 16% from its year-ago levels - which makes U.S.-poured steel more attractive abroad and likewise makes imported steel less economically attractive in the U.S.; a step-up in steel demand from China, which sops up much of the output from such Far Eastern producers as Japan's Nippon Steel and Korea's Pohang Steel, output that might otherwise wind up in the U.S.; and the shakeout in the domestic steel industry, which has resulted in a reduction of overall capacity, the shedding of debt and pension "legacy" costs for industry retirees and the consolidation of much of the industry's assets in the hands of more financially stable companies, such as United States Steel Corp., which absorbed the assets of the old National Steel Corp., and the acquisition of the assets of the former Bethlehem Steel Corp., LTV Corp. and Acme Steel by the International Steel Group.

One name Kirchwey likes as a possible turnaround play is Weirton Steel Corp., currently undergoing reorganization under Chapter 11 and expected to emerge from bankruptcy later in 2004 with reduced labor costs, including pension plan obligations, and reduced debt. "When WRTL emerges from Chapter 11 proceedings in 2004, it should be able to compete with ISG and others on a roughly equal basis," the analyst wrote in a recent research report.

Meantime, AK Steel Corp. - whose bonds at one time traded near par, when the company was considered one of the few stable, well-run companies in a sector that otherwise was a disaster area - "must produce its steel with an overhead that includes paying current interest on its debt burden, paying retiree medical costs, and is committed to funding its pension plan," Kirchwey wrote.

Even with those very large competitive negatives, however, AK's bonds - which had fallen into the 60s earlier in 2003 - had managed to claw their way back into the 80s by year's end, carried along by the overall sector strength. With the whole steel group having momentum, the analyst said, "I would really expect to see some strength in steel in January and February, possibly as long as March. It depends how long the rally lasts."

The easy money has been made

Taking a look at another troubled industry sector which seemed to have a revival in 2003, Kirchwey said that "the recovery of airline bond prices was remarkable - that was probably the strongest performing sector." However, he warned that "there's not much more climbing they can do, with the unsecured bond prices of the major non-bankrupt airlines in the 80s and, in the case of Delta, in the 90s. There's not much more room to go."

Kirchwey said that after having gained that kind of altitude, "I've been advising our clients to sell at those levels at any time that they need to get some cash and realize their profits for the year. There's nowhere further up to go and lots of downside as the industry enters its six-month slow period for the fourth quarter and the first quarter of any year, the travel season is slow."

In Boston, Frederick Taylor, director of high yield research at Fleet Securities, likewise feels that in the homebuilding sector - another industry which had a very good 2003, helped along by sharply lower interest rates, "most of the easy money has already been had," with virtually all of the sector names now trading at, or in some cases, well above par.

Be that as it may, though, Taylor still feels that there are names in the sector definitely worth hanging onto.

"I think the return in homebuilding, most of that is gone, and what you have going forward is two or three of these like KB Home and D.R. Horton going investment grade in 2004, and you can see their spreads go from 225 basis points [over Treasuries] to 125. So you can still see some total rate of return in homebuilding if they go investment grade, and I think a number of them will get upgraded in the new year."

As for other areas which may not have had quite the appreciation that the homebuilders have enjoyed and where there might be room for some upside in 2004, even if the names remain junk-rated, the analyst said: "I think lodging can do well, as corporate travel budgets will be higher" in 2004. "Lodging can do very well, and as economic activity picks up, I think packaging can do well."

On the other hand, he urges caution when it comes to an area such as automotive parts suppliers, even though the overall pickup in economic activity and increased consumer confidence, as well as continued relatively low interest rates, bode well for Detroit's Big Three and other carmakers, who in turn buy components from such companies as Lear Corp., Tenneco Automotive, Collins & Aikman Products Co., Dana Corp., Dura Operating Corp. and J.L. French Automotive Castings.

However, Taylor notes that the carmakers are putting continued pressure on their suppliers to cut prices, which could put the latter's revenues under pressure. Investment in such a sector should only be "on a credit-by-credit basis."

Overall, he says, the junk market should earn a return somewhere around 8¾% and default rates "will continue to come down, though at a slower pace. The market will mostly be a coupon-earner."

Taylor doesn't see a continuation of the same kind of liquidity surge in 2004 that buoyed the market in 2003, although he also does not expect any major outflows. Even with a slower pace of inflows and total market returns back in the high single-digits from 2003's nosebleed levels, the Fleet analyst declares that "with the Dow above 10,000 and defaults coming down, and the likely rating upgrade environment at the ratings agencies, high yield will still be a good asset class to be in in 2004."

Year end forecasts? Bah, humbug.

One well-known watcher of the high yield world who is not making any year-end prognostications and who in fact doesn't think very much of the whole concept is Martin S. Fridson, who doubtless had his fill of such late-December soothsaying during the years when he was chief strategist and managing director for global high yield strategy at Merrill Lynch & Co.

Fridson - always something of a puckish iconoclast, even when he was with the Big Bull - now publishes his own weekly journal, Leverage World, and he wrote in a recent edition of the Wall Street tradition of publishing annual forecasts purporting to be accurate investment roadmaps for the coming 12 months that "the custom is harmless enough, provided nobody takes the output seriously . . . the great unanswered question about the yuletide prognosticating rite is why investors think that trying to peer 12 full months into the future is anymore worthwhile at this particular point of the year than at other times.

"Surely the answer cannot be that December forecasts have proven more reliable than forecasts made in other seasons. Neither is it likely that the portfolio managers who remain employed have done so by determining their overweights and underweights at the beginning of the year, then stubbornly sticking to them for the next 365 days, regardless of intervening unforeseen changes in the investment environment."

Fridson may have something there. Certainly, it was a year ago that Prospect News, after consulting bond traders, analysts and portfolio managers, reported that the general Wall Street consensus was that 2003 would likely be at best a "cautiously optimistic" year in the primary market, perhaps racking up new issuance in the $60 billion to $80 billion range, not much above the anemic $59 billion which had priced in 2002; the outlook for the secondary market meanwhile seemed "uncertain" at best, with the landscape littered with the wreckage of once-formidable companies that blew up in 2002 and market participants wondering which shoes would be dropping in 2003, and predicting best-case scenarios featuring relatively modest returns.

The reality of course, is that fueled by an unprecedented surge of liquidity, new issuance soared to a near-record pace of $139 billion; the secondary market meantime, with liquidity rising and default rates unexpectedly tumbling, also broke all kinds of records in racking up total returns of nearly 30%, with the year marred by only a relatively few untoward events, such as the Parmalat fiasco.

Speaking of which, a distressed debt trader said that the swift collapse of the company had completely caught denizens of his world by surprise.

"Two months ago, who could have predicted that we [a distressed-debt shop] would be trading Parmalat? Yet here we are - we've started doing it, and I'm sure we're going to be doing a lot more of it in the coming weeks and months," he exclaimed - another indication, perhaps that it is difficult to state with too much accuracy what lies too far ahead.

Fridson noted that according to one market source with whom he had spoken, the most aggressive junk bulls at the end of 2002 had predicted a return for 2003 of perhaps 15% - never dreaming that the actual return would almost double that.

"The gap is no cause for embarrassment to the strategists," Fridson wrote reassuringly, "but rather a comment on the erratic character of the high-yield market. Even the best minds are not up to the task of divining what detours and collisions lie on its future itinerary."

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