Outlook 2005: Fewer new deals but total still seen beating $100 billion

By Paul A. Harris

St. Louis, Dec. 31 - At the outset it is worth noting that a unanimous chorus of sell-side voices, polled almost exactly one year prior to the writing of this piece, told Prospect News that there was no way that 2004 could see new issue volume that would top that of 2003.

One year hence that chorus, much to its jubilation, has proven itself to have been wrong.

Although counts vary because different counters use or exclude various fields of bonds, most counts show the market setting a new record in 2004.

According to data compiled by Prospect News, the U.S., dollar-denominated new issue market turned out $142.378 billion of issuance in 575 tranches of high yield bonds in 2004. That compares to 2003's $138.483 billion in 506 tranches.

Issuers from industrialized countries, counting all currencies, totaled $153.595 billion in 615 deals in 2004 versus $137.528 billion in 508 deals, according to the Prospect News data.

Less issuance forecast

In keeping with those late 2003 forecasts, sources polled late in 2004 predicted that the year ahead will see less new issue volume than it saw over the past - record-breaking -12 months.

None of the sources, however, forecast issuance of less than $100 billion.

Most expressed the belief that refinancing issues will diminish as a portion of overall activity, therefore reducing new deal volume in its entirety.

Banc of America Securities is forecasting $125 billion versus the $156 billion for 2004.

In the firm's 2005 outlook, published Dec. 21 in its Credit Market Strategist, Jeffrey Rosenberg, head of that institution's credit strategy team, wrote: "Speculative-grade issuers took advantage of the low interest rates and the favorable technical environment, bringing out a record volume of notes offerings. Full-year 2004 volume is expected to total $156 billion, shattering the record of $140 billion set last year.

"Primary activity is expected to slow down somewhat in 2005, with our estimated total supply to be around $125 billion."

Meanwhile a senior high yield syndicate official from another major investment bank, speaking on background, forecast total issuance of approximately $115 billion, with an increase in the proportion of issuance that actually puts investor cash to work.

"There are a lot of moving parts," the source said. "The biggest one in 2005 will be fallen angels," the sell-sider added, saying that this often unwelcome class of bonds, which enters the high-yield universe from the investment-grade class of credits, is expected by some observers to have "a big impact" in the 12 months ahead.

"But the pure financing game has dramatically lessened," the source added.

This official specified that issuance which actually results in generating new bonds, as opposed to bonds that simply replace other existing notes via refinancing, will increase as a proportion of overall issuance in 2005.

"Out of 2004's $154 billion market more than 50% were refinancings," the source said. "That means that the market actually soaked up $60 billion to $70 billion of new cash.

"I think refinancing will be below 50% in 2005 for the first time in a long time.

"That will make supply and demand come a little more into balance."

This official also expressed the expectation that the January new issue calendar will be "relatively robust, but not as heavy as December."

Merrill Lynch & Co., meanwhile, sees the present market technicals, where demand outpaces new issue supply, continuing into 2005.

"New issuance will likely continue to fall short of demand," wrote Merrill Lynch high yield strategist M. Christopher Garman. "The strong technical bid for secondary paper will likely remain.

"Despite the ongoing quest for yield, high yield investors are still likely to shy away from another bout of 'business plan' lending in the wake of 1997-1999's 'bad tranches.'

"Instead, leveraged buyout and acquisition-sourced paper would be an ideal restorative to the current cheap debt, slack-heavy corporate environment - i.e. the U.S.'s 'sunset' industries (likely those that compete head-to-head with Asia) can lever up, take out equity, cut excess capacity and consolidate - a source of new issuance.

"However, high yield investors will likely find themselves in competition for yield in a cash- and liquidity-rich environment - which suggests that U.S. dollar-based growth opportunities will price out quickly, whether from the actions of corporate boardrooms, private equity investors, hedge funds, or the like - and thus pricing out a segment of high yield new issuance."

Elsewhere a high yield strategist at another major investment bank, also speaking on background, foresees less issuance ahead, specifying that U.S. fixed-rate high yield issuance is expected to top $100 billion for 2005.

More M&A in 2005

Kingman D. Penniman, president of KDP Investment Advisors, reminded Prospect News that the market was expecting a dramatic increase in merger and acquisition-related issuance in 2004. Penniman believe that while M&A issuance ultimately did not predominate '04, it could do so in the year ahead.

"We've said it before - and found out we were wrong, with the crossovers that came in November - but we think a lot of the refinancing has taken place, and we're looking for issuance next year to remain above $100 billion plus, and we think that a good 30% to 40% of that is going to come from M&A activity," Penniman said.

"That's the one thing the market has over-estimated; we thought that 2004 would see a lot more M&A activity than we did because there was so much refinancing in 2003, and we were wrong, because they continued to refinance in 2004, given what happened with interest rates.

"So I think in 2005, a lot of the issuance coming in the market will be for M&A activity."

A busy January, then who knows?

Most syndicate officials polled, meanwhile, like the source quoted above, see 2005 getting off to a strong start.

However not one source was willing to project beyond the end of the first quarter of the new year.

"Our calendar is pretty solid," said one high yield syndicate official from a major investment bank in late December.

"January won't be as busy as December, but it will be solid market."

This source, who said his firm had tallied "over $154 billion" of high yield issuance in 2004 expressed doubts that 2005 will meet or top that level.

Another syndicate source from another big investment bank had much the same color.

"It feels like we are going to have a pretty busy calendar in January, based on people I have talked to, and what we have going on," this official said.

"Coming out of the box I think we will pick up just about where we left off."

And this source also said that the 2004 issuance record does not figure to come under assault in 2005.

"I think 2005 is going to be a somewhat tougher year," the source said. "If you look at what has been done from financing perspective, and how much more refinancing is out there, you get the impression that we're coming to the end of that big bulge.

"I think issuance is going to be drive by acquisition financing and by opportunistic financing. But it's going to be tough to beat where we were this year."

When Prospect News asked this source whether the dividend funding deals - a plethora of which had been seen during the final weeks of 2004 - could still be a possibility in a market where demand outstrips the supply of high-yield assets,

"Yes," said the sell-sider, "but one of the mitigating factors will be that corporate balance sheets are in good shape. People have cash. Equity valuations are moving up.

"Your strategic buyer could become more of a player, pricing out some of the LBO shops."

Europe also seen starting busy

Meanwhile a sell-side source in Europe also sees 2005 getting of to a strong start.

"We saw €15.4 billion this year," the official said.

"The coming year is expected to be good. There are a lot of LBOs in execution, several very big ones that should generate amounts in the €750 million to €1 billion range in high yield.

"So the first quarter at least is expected to be big.

"The rest of the year is harder to tell, although what 2004 has shown us that corporate deals can pop up onto the radar screen quickly and get executed.

"Finally, deals done in 2001 and 2002 will be viewed as potential recap or call situations.

"The market is growing up slowly and seems to becoming more stable."

Prospect News' data puts European issuance for 2004 at €14.621 billion in 63 deals plus a further £1.699 billion in 11 deals.

As to the busy January that the above-quoted sources anticipate, very few concrete details had been heard around the market as December wound down.

PanAmSat, the Wilton, Conn.-based satellite communications company, told Prospect News that it intends to sell bonds in the new year. And market sources have speculated that the bond deal, which is coming in conjunction with the company's Morgan Stanley, Citigroup and Merrill Lynch & Co.-led $1.12 billion IPO, will be January business.

Also in the high-yield skies, in an orbit that some sources say will bring an early 2005 transaction, is Intelsat.

In early December the company postponed its $2.55 billion offering of high-yield bonds until early January.

Private equity group Zeus Holdings Ltd., formed by private equity firms Apax Partners, Permira, Apollo Management and Madison Dearborn Partners, was re-evaluating its takeover of Intelsat in light of the satellite telecommunications company's recently reported electrical difficulties with its Americas-7 satellite.

The junk bonds are being sold to back the proposed $5 billion acquisition.

Deutsche Bank Securities, Credit Suisse First Boston and Lehman Brothers are leading the deal.

The liquidity picture

One emergent theme during 2004 was the strong and strengthening position of the buy-side, and the contention, by nearly all participants who spoke to Prospect News throughout the year, that this cash position is no longer accurately depicted by the reports of inflows and outflows to the high-yield mutual funds.

The funds flows reports are made by AMG Data Services, of Arcata, Calif. And the number that most sources key on is the amount of weekly funds flows without distributions.

Late in the final week of 2004 AMG reported an $87.5 million outflow for the week to Dec. 29, the sixth consecutive negative flow.

That brought the year to a close having undergone outflows in 26 of 52 weeks, and having posted negative $3.235 billion of net flows during that period (see related story elsewhere in this issue).

Sources on both the buy-side and the sell-side have been telling Prospect News that despite the negative numbers reported by the high-yield mutual funds, the speculative-grade bond asset class remains highly liquid, with insurance funds, pension funds, crossover investment-grade funds, CDOs, CBOs and others attempting to put cash to work in the market.

One sell-side source's color is characteristic: "Those weekly funds flows numbers are now thought to reflect the sentiment of the market. However right now they don't give an accurate reading of the market's liquidity."

Sources polled late in the year anticipated that the dichotomy between the reported funds flows and actual high yield liquidity would carry forward at least into the early months of 2005.

Forces at play going into 2005

Martin Fridson, the noted high yield strategist who publishes Leverage World, the weekly publication of high yield strategy, said that rising defaults, a rallying stock market and a declining dollar all could conceivably impact new issuance in 2005.

"There is still a lot of money coming into high yield," Fridson said,

"A modest rise in the default rate should not have too much impact," he added, alluding to an early December report from Moody's Investor Services, in which the ratings agency professed the anticipation that defaults will decline over the short term, ending 2004 at 2.3%, before bottoming out at approximately 1.9% in March 2005, then turning higher, rising to 2.6% by November 2005.

"The one thing that could change is if the stock market starts to do better," Fridson commented on Dec. 22, the day after the Dow Jones Industrial Average closed at 10,759, its highest close since June 13, 2001.

"A rallying stock market could start to attract a lot of capital that has gone into high-yield bonds," Fridson said.

"The other wild card is the dollar, which has an indirect effect on the high-yield market. That could start a chain effect in which money would flow out of high-yield bonds, if it happened."

There's still a way to run

Quizzing high yield sources as to whether the present rally will come to an end, you predictably receive an affirmative response.

However none of the sources on the buy-side or the sell-side offered anything remotely resembling a timeline.

The preponderance of opinion holds that high yield still has a way to run.

When, for example, Prospect News asked Mike Difley, vice president and portfolio manager of the American Century High Yield Fund, how long the rally would last, he simply said: "That's anyone's guess.

"I still think high yield could have some kind of correction at any time," he added. "However it is difficult to see the immediate catalyst unless investors drop their hands and decide that things are just too tight.

"The fundamentals are probably going to be pretty decent in 2005. And you're obviously seeing a lack of supply when you have these holdco dividend deals that we have seen in December."

Like Fridson, Difley believes that significant cash is continuing to flow into the junk market despite the negative picture painted by the weekly high-yield mutual fund flows numbers published by AMG Data Services.

Asked whether interest rates could be the X-factor that squelches the junk rally, Difley was inclined to think not.

"The story has been out there for some time and we still have not seen the impact yet," he said. "I don't know if we're going to get the big backup in rates. The yield curve seems like it's just content to flatten at this point.

"I think that the Fed is on a path to continue to tighten," he added.

"However some will argue that Fed Funds rate is almost at neutral now, and that they may not have that much more to go.

"They have said that they are going to be data dependent. So if they get weak employment reports or other weak economic data you may see them back off. But if the trajectory of the economy keeps continuing upward obviously the Fed will continue its policy of slowly tightening.

"They have said that they are going to be measured in their pace, and they have been true to that so far."

One force that could stop the rally, according to Difley, is inflation.

"If you start to see that a pickup in a way that was unanticipated by the market and it triggers a quick and rather violent sell off in the bond market, junk is going to be affected," he said.

"Recently the correlations have been very high between the direction of the Treasury market and the direction of high yield.

"And given where yields and spreads are now I think that is exactly what you are going to continue to see."

2004: year of the low-quality credit

Through most of the latter half of 2004 the story in high yield was the cash that needed to be put to work in the asset class, and the lack a supply of new paper to soak that cash up. Owing to the lingering demand for new bonds, companies with low single-B and even triple-C equivalent credit ratings were able to complete junk bond deals.

Although sources told Prospect News that investors did mount resistance to certain weak credits during the closing months of 2004, generally the deals were said to have gotten rich and richer, even as credit quality slid.

In the Dec. 10, 2004 issue of Leverage World, Fridson assessed year-to-date new issuance through the end of November in terms of credit quality, which he deems to be historically low.

"The year now ending will go down as the worst in history in terms of high-yield new issue quality," Fridson wrote. "Through Nov. 30, 2004, according to Merrill Lynch, 33.9% of primary volume, by principal amount, has been issued by companies rated B-minus or lower by Standard & Poor's at the senior equivalent level. The highest previous comparable was 29.4% in 2000. As recently as the more credit-conscious year of 2002, issuance by bottom-tier companies accounted for just 10.0% of volume."

The upsurge in issuance from weaker credits, to some, implies an increase in the risk of defaults ahead. However one buy-side source, speaking on background, said that this is not necessarily the case.

"The question is the portfolio manager's perception of risk," the buy-sider said. "If a portfolio manager believes there is high risk in the high-yield market he should go to double-Bs and live with the Treasury risk.

"If he believes the agencies are too slow to upgrade coming out of a recession and the triple-C aging effect still gives the market a year or so, he should overweight triple-Cs (if he is nimble, and beating the high yield benchmark is his goal). If the portfolio manager has no real clue, he's automatically not adding value and assuming index weights is therefore the only fair thing to do.

"It would not be wise to assume that a large percentage of triple-Cs implies an exceptionally high level of credit risk," the buy-sider continued. "There was a lot more credit risk in 2002 despite that low level of issuance, and not coincidentally. A lot of big issuers were downgraded back then and are improving now, spending some of 2004 refinancing (improving) their capital structures before the agencies give them upgrades.

"When times start turning tough again and the triple-C percentage is still high, then you can make the case there is an exceptional degree of risk in the market."

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