Fitch: Market conditions favor U.S. high-yield market in the near term

By Angela McDaniels

Seattle, Dec. 14 - Fitch Ratings said that as 2006 winds to a close, market conditions appear to favor continued improvement in the high-yield market, at least in the near term.

In a news release, the agency noted that:

• Despite consistent interest rate increases by the Federal Reserve Board, the cost of capital remains relatively low by historical standards;

• With the recent pause in rate hikes by the Fed, interest rates have begun to stabilize and even decline;

• Energy prices are beginning to fall and inflation appears to be in check;

• Liquidity is at record high levels with the increase in market participation by hedge funds and structured vehicles. Unlike most previous periods when the United States was entering an economic slowdown, high-yield companies are flush with cash and have generally improved their balance sheet by either reducing debt levels and/or extending maturities; and

• Default rates are near historical lows, and recovery rates, defined as the average trading level of bonds 30 days after default, are at record highs at nearly 75%.

Risk factors

However, Fitch said there plenty of things that could go wrong.

Although the risk/reward trade-off for high-yield bonds is among the best of the various capital market instruments, the volatility of those returns is significant and, despite current market complacency, the risks appear to be rising, according to the agency.

New issue quality is deteriorating as evidenced by the high level of lower-rated issues and the downward rating migration of recent leveraged buyout transactions, Fitch said, adding that improvement in corporate financial metrics is slowing, covenant packages are weakening and total debt maturities are rising.

Other risk factors in this credit cycle mentioned by Fitch included the high levels of senior secured debt (leveraged loans) issued by speculative-grade companies, which could result in little value accruing to unsecured creditors in the event of default, and the huge increase in foreign investment in U.S. debt securities, which would have a decidedly negative impact if withdrawn.

External event risk will also remain a major concern for high-yield investors in 2007, particularly as the U.S. situation in Iraq worsens and the threat of terrorist activity remains high.

Fitch said that significant unknown factors in the current credit cycle include the rapid recent growth of the credit derivatives market, which now exceeds the size of the cash market; recent changes in U.S. bankruptcy laws; the proliferation of collateralized loan obligations, hedge funds and structured vehicles; and large capital flows into private equity funds, which continue to drive their appetite for increasingly large and risky acquisitions.

Investment return

The agency believes that high-yield market participants could expect to earn their coupon (the yield to worst on the Merrill Lynch High Yield Master II Index is presently about 7.7%) over the next year if the economic soft landing scenario materializes, but this is probably about the most they should expect.

As of Tuesday, the option-adjusted spread on the Master II Index stood at 306 basis points, near the record low spread of 271 bps set on March 9, 2005, according to the release.

Fitch said such a tight spread over U.S. Treasuries would appear to limit the price upside of high-yield bonds during 2007, barring an unexpected rally in the U.S. Treasury market. Given that price is a key component of bond performance, this would in turn limit total return.

On the downside, if the economy slows more than expected or if a significant exogenous negative event occurs, the total return for the high-yield market could be significantly lower than that experienced in 2006, the agency predicted.

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