Outlook 2008: Signs of life in the junk market after subprime debacle

By Paul Deckelman

New York, Dec. 31 - When the high-yield market came cruising across the finish line at the end of 2006 unexpectedly sporting average returns of more than 10% and spreads over Treasuries in the low 300-basis points range, all floating on a soft cushion of easy liquidity provided by hedge funds and other eager players looking to get in on what was then a swelling boom of leveraged buyout deals and other merger and acquisition-type transactions, most analysts, traders and other market professionals cautioned everyone to enjoy the good times while they could, because the party probably would not last.

They didn't know at the time how very right they were.

Fast forward a year - and behold a junk market barely staggering across the finish line with a positive return of not even 2% - only about one-quarter to at most one-half of what the savants were predicting heading into the year. At the same time, spreads had ballooned out to about double where they began the year. The easy liquidity that made the 2006 advance possible - and that kept it going at a brisk pace through the first half of 2007 - is gone with the wind.

And who would have thought that with all of the possible culprits in a position to undermine the junk market's advance and spoil any hopes of notching two big years in a row - from rising oil prices to recession fears to the prospect that many of the bond deals done in the frenetic period of 2003-2004 (when over $290 billion of new junk priced) had reached the traditional 3-4 year window during which deals are in the greatest danger of blowing up - the market's momentum would be stopped cold by The American Dream of home ownership?

The Dream becomes a nightmare

By now, the causes of what has come to be called the "subprime mortgage crisis" have been well documented - in brief, the too easy extension of credit by too eager lenders to unqualified buyers unequipped to handle the higher payments which kicked in when their adjustable-rate mortgages reset to higher interest rates. Reluctance among mortgage lenders made it difficult for those borrowers to refinance their loans at an affordable fixed rate and lower home prices made it difficult for them to sell their houses when they got in trouble. The result was an unprecedented wave of defaults and foreclosures.

Those problems in turn knocked the bottom out of the market for mortgage-backed securities that used large pools of residential loans, including subprime mortgages, as collateral, drying up the major funding source for mortgage originators and causing the holders of the securities, including hedge funds, banks and other financial institutions around the world to collectively book losses approaching $100 billion when the value of such subprime-tainted holdings were written down or written off altogether. The damage to the mortgage market completely sapped what little strength was left in homebuilding, whose much-heralded "boom" had been considered over since 2005, under the pressure of an onslaught of monthly Federal Reserve interest rates aimed at fighting inflation (the key fed funds target rate had risen from 1% in mid-2004 to 5¼% just two years later) combined with a glut of existing homes on the market at unrealistically high prices.

This financial "perfect storm" hit the junk market around mid-summer. By August, major loan originator Countrywide Financial Corp., the nation's largest, was being talked of as a possible bankruptcy case due to a funding squeeze. Its nominally investment-grade rated bonds were being traded off junk desks at many shops, some at badly distressed levels.

A similar fate met the formerly investment-grade rated bonds of competitor Residential Capital LLC, as that big mortgage originator's finances were hurt by the ongoing credit crunch and its ratings were dumped to junk. That in turn had ripple effects, pulling down the financial performance, credit ratings and bond prices of ResCap's corporate parent, GMAC LLC, now one of the most actively traded junk names on any given day, and also towing the latter's 49% owner, automotive benchmark issuer General Motors Corp., lower. GM, of course, was also wrestling with its own problems in 2007, notably the continued erosion of the U.S. automotive industry's domestic market share (also a concern for arch-rival Ford Motor Co.), but the subprime-related problems of ResCap and GMAC were certainly no help.

And the subprime situation even put a crimp in the funding and hurt the bonds of such companies as Thornburg Mortgage Inc. - even though the latter company does not do any subprime lending at all, largely doing jumbo-sized mortgages at the higher end of the credit spectrum.

Not just a subprime problem anymore

"People keep referring [to the current credit crunch] as a 'subprime problem'," declared Bill Featherston, managing director at J. Giordano Securities in Stamford, Conn., "but it's not a 'subprime problem' - it's now a loan problem. All of the loans are being questioned. Even the super-senior loans were [recently] downgraded by one of the ratings services."

Featherston acknowledged that there was a strong element of guilt-by-association behind ratings-agency action downgrading asset-backed and mortgage-backed securities which had any kind of subprime component.

"Typically, the subprimes represent a fairly small percentage [of the collateral] - 10% or 12%, with the remainder being made up of mezzanine loans, the next level, then senior and super-senior. But as the saying goes, the fish stinks from the head [down]. They're going right up there to downgrade some bonds that were thought to be rock-solid."

About a year or so ago, Featherston said, Giordano was faced with a high yield bond market that was on a spread-tightening binge that sometimes made junk appear to be little more than "investment-grade light," as one trader notably put it at the time, and saw even a distressed-bond market that held not very many opportunities for really making serious money. The company began devoting resources to other areas that might have more promise - among them asset-backed securities, particularly in the MBS market. It was a prescient move that has paid off - and the managing director said: "I hate to be cynical, but that's going to be a gift that keeps on giving," with the financial markets only in "the early to middle stages of a real credit crunch." There is, he predicted, "going to be more forced selling from institutions."

Retailers on the spot

Back in junk bond land, Featherston said, the ongoing credit crunch is likely spread beyond just the housing and financial sectors; for instance, it has already started to hit retailers and restaurants pretty hard, since it has "taken away the pocketbook that home-equity loans provided" to consumers. He explained that unless things change dramatically, "money is going to stay relatively tight. Just because it's out there [in terms of recently enhanced financial-system liquidity due to Fed actions], "it doesn't mean the lenders are going to loan it to applicants. They've raised their lending standards dramatically for all but the very best buyers."

That translates to less discretionary spending. "We've seen it already," he declared.

The Giordano managing director noted that while retailing behemoth Wal-Mart Stores' most recent numbers, reported in November, were "decent," another big retailer, Home Depot, failed to follow suit - a sign, he said that the current troubles "are certainly going to have an roll-over effect onto retailers."

In a similar vein, analyst Bob Lupo of Libertas Partners in Greenwich, Conn., said that "the sub-prime mortgage mess and the housing decline is more or less going to shut the ATM window on home equity loans," a development which has particularly ominous connotations for retailing, since up until now the easy availability of home-equity credit had powered the retailing sector, sometimes for big-ticket items such as car purchases - many consumers would buy cars and then typically refinance their auto loans through home equity, usually lowering their interest rate and gaining tax deductibility of the interest to boot. Similar strategies also helped to fuel smaller purchases usually paid for by credit cards, since consumers would freely use home-equity lines of credit to pay off their higher-interest credit card debt.

On top of the likely loss of such financial flexibility, Lupo noted that consumer spending is also being pressured by higher energy costs, food costs and other day-to-day expenditures, leaving the consumer strapped - always a bad thing for a U.S. economy that is about 70% dependent on consumer spending.

"We are negative on the retailing sector as an investment category," he declared. He said that high-yield retailers like Burlington Coat Factory, Claire's Stores and Bon-Ton Stores "have been posting negative comps [same-store sales comparisons versus year-ago levels] and squeezed margins."

Even higher-grade retailers such as Kohl's have had to knock "40% to 50% off" many prices in order to keep sales up - good for revenues but terrible for operating profit margins, while sector peer JC Penney "has also been aggressive. This season has been marked by an intensely promotional tone" across the retailing spectrum.

Looking ahead, he expects more of the same with "very little visibility, at least in the early part of the year," making it likely we'll see "a continuation of currently weak trends."

Restaurant financials eaten away

Giordano's Featherston also sees an unappetizing year ahead for restaurant operators, which, like retailers, are very much tied to how much income consumers feel they can spend.

For instance, with less discretionary income and higher gas prices, "some of these middle-tier restaurants [i.e. casual-dining companies such as Buffets Inc., Outback Steakhouse/OSI Restaurant Partners, Perkins Restaurant and the Darden Restaurants' chains like Red Lobster and Olive Garden] that are dependent on middle-class people driving to them will see people cutting back from middle-tier restaurants to fast-food," although there was also the possibility, he said, that the middle-tier operators might pick up some trade from people no longer going to even more costly full-service restaurants.

Bob Lupo's colleague at Libertas, analyst Aqeel Merchant, pointed out that not only will the casual-dining eateries, a group which also includes the likes of Denny's and Uno's, be pressured by consumers cutting back on their dining habits, but also on the cost end by upward pressure on commodity prices for such items as cheese and other dairy products and wheat products.

He said that most of the casual dining operators "have been posting mixed-to-negative comps" for most of the quarters over the past year, in a negative 1% to negative 3% range, "so it's been tough, and it's getting tougher."

A trader at another shop was bearish on the fortunes of the retailers and restaurateurs. Some names in the sector, he said "are down between 20 and 30 points" from where they were trading in the springtime or even six months ago, in mid-summer.

He said that Bon-Ton, Burlington, drug chain operators like Rite Aid Corp., supermarket names like Stater Bros, Inc. and restaurateurs like Sbarro's Inc. - "your retailers, anything in the mall, your food stores - everything like that, from what I can see is under a ton of pressure."

He said that while some of the quarterly numbers that came out for such companies were "okay," they were "not what they had anticipated - and I can't see next year [2008] doing better than where we are now," given the mortgage crisis.

"We haven't even seen the ripple effects of people losing their homes, people stop buying, the consumer dropping off - and then all of these highly leveraged companies getting their butts kicked, one because they don't have customers, or two, their ability to refinance has become so difficult that they can't do it." He said that the over "the past five or six years, it's been like free money" in the junk market - "you need money, you do a new deal. You need more money, you do that deal. It's like a house of cards."

While some companies have managed to pay down debt, he cited others, like Michaels Stores Inc., which took out some high-coupon bonds a year or so ago - only to return to the junk market in mid-2006 for even more new debt in a multi-tranche mega-deal. "The list keeps going on and on and on."

A second trader was a bit more positive on the sector - but only a bit. "I think you could buy the retailers," he advised - "but you've got to buy them at a cheaper level than they are now. You have to get to a point where they really get discounted and then I would get involved."

At KDP Investment Advisors Inc. in Montpelier, Vt., company president and founder Kingman D. Penniman said that "depending on what happens to the consumer, you could see certain [retail] names under pressure. You can also see technology, which has been everyone's favorite [come under pressure] - depending on the economic environment, there could be some sudden surprises."

Cyclicals a question mark, healthcare a haven

However, he said, said "the question that everyone will be looking at carefully right now" concerns the outlook for cyclical companies.

"Although we have high commodity prices and a lot of exports, if the economy weakens substantially, some of those sectors that are gaining and continuing to respond to the foreign export markets could see some dramatic downdrafts in their financial numbers. In the economy we foresee, there may be some unpleasant performance." However, he tempered that bearish forecast a bit, adding that "we don't see them joining the Club of Defaults for 2008."

Penniman likes healthcare, consumer staples and "some of your manufacturing companies that do have a strong export base, and credits with free cash flow " as defensive sectors in such an economy.

What will differentiate the market in 2008 from preceding years, he said is that "in the past, since the market wasn't penalizing for credit risks, with tight spreads and [virtually] no defaults, people did well by overweighting CCCs and buying the highest-yielding, lowest-discount prices and then watching them go up and outperform. I think that this [2008] market will be the opposite - it will be a bond-picker's market in trying to understand the credits. You can have credits in bad industries - but if they have free cash flow, they will do well."

Outperformance for the coming year, he said, "will not be by [picking] the riskier credits, and watching them go up as spreads tighten," as was the case in 2006 and early 2007, "but by avoiding the bombs, where credits will gap out wide because of concerns over credit quality."

He added that "the sectors that were the gainers the last couple of years are likely to be the buckets that have most of the losers this [coming] year."

Housing not that horrible?

Surprisingly, though, Penniman is not totally down on the homebuilders and the mortgage providers, which bore much of the brunt of the second-half market downturn in 2007, feeling that sector may be poised for a turn.

He said that over the last several weeks, "both the homebuilders and some of the financial services companies have come back," particularly ResCap, since it announced its recently concluded $750 million bond buyback just before Thanksgiving.

He also cited Standard Pacific Corp. as an example of a homebuilder that has come back from even lower levels. While "it's not out of the woods, people are trying to decide where the bottom specifically in homebuilders is going to be."

However, he cautioned that trying to find a bottom in the sector will be difficult and trading volatile because "those are favored [vehicles] for shorting, so you see bonds either go up or down in price in a dramatic and vehement way because you see people either shorting or covering their shorts." Lately, he said, investors have covered shorts in homebuilding and mortgage originators on the news that the federal government had announced programs to help some homeowners with mortgage problems.

"The story with the homebuilders is that when they are not building and are selling land, they're potentially going to be in a position to build their free cash flow, which will enable them to service their debt to survive this period they're in."

"The homebuilders, the ResCaps [and similar credits], at certain prices, they could be great investments," but he urged "picking carefully through that area."

A trader was also mildly optimistic about the builders, suggesting that having "already imploded," the sector was unlikely to keep falling, with prices "already pretty well discounted to worst."

A more bearish viewpoint

However, Fitch Ratings managing director Robert Curran took a very cautious view of the housing sector, noting that 2007 was the second-year of its decline - and was "much more steep" than 2006 had been, adding up to "a pretty significant decline by historical standards" over the two-year period. And "it's not over yet" - the correction is likely to extend well into 2008, the ratings agency believes, "with some ferocity."

While there is a big backlog of unsold new homes that must be whittled down in order to give sales a chance to pick up, Curran noted that new-home prices have been coming down to more salable levels because the builders have been "reasonably aggressive" in lowering prices to spur sales. One widely publicized stunt was Hovnanian Enterprises Inc.'s 72-hour "Deal of the Century" weekend price-cutting blitz in mid-September, although Curran dismissed that as mostly a "nice media event" whose impact was "overstated" by the press. He pointed out that it was a "very targeted" promotion, limited mostly to finished or nearly-finished homes in selected geographic regions, rather than the company-wide fire sale that some media outlets made it appear to be (the event did, however, push the builder's junk bonds up solidly for about a week). He said other builders have already also cut prices, though with considerably less fanfare, and it is quite likely that Hovnanian and its peers might indulge in further promotions.

But Curran noted that there's an even larger number of existing homes out there waiting to be sold - and this housing glut can only be solved through a combination of time and pricing, with homeowners trying to unload existing houses having to accept less than they originally wanted to in order to make their sales. Unlike the builders, he said, existing homeowners "have been slower to adjust to the realities of the market."

Curran said that the cost of homes themselves, rather than the cost of credit needed to purchase them, is what is primarily ailing the homebuilding industry right now.

"Home prices need to come down further, directly or indirectly," he declared, through more builder incentives and especially, lowered prices for existing homes. With the Fed having recently cut interest rates several times, and with mortgage rates linked to overall rates, a downturn in interest rates might help a little - but he said that it is "hard to envision" rates on 30-year fixed-rate mortgages declining "significantly" enough at this point to have more than just a marginal impact on home sales, noting that they are already "quite attractive" at under 6% on average, "pretty low" by historic standards. The building industry and the mortgage lenders had already liberalized their lending terms in order to reach less-credit-worthy people during the "up" portion of the cycle - "and it is in that context that people have run into trouble."

He said that market psychology will play a part in the revival.

Assuming they can qualify for a loan under newly tightened standards - nobody, he said, is currently writing any new subprime mortgages - people will buy when they think it is "the right time for them to buy" - but added that while heavy media focus on pressure on home prices and concerns about the economy may keep some people "on the sidelines, waiting for what they think will be a better time to buy," a variety of factors, of which price is only one, typically drive home sales, including the need for more space for growing families and the desire to trade up to a nicer neighborhood. That having been said, though, price will still be an important consideration.

As to when such a revival will happen, given most economists' forecasts of "restrained growth" of 2% or less, Curran said that Fitch's "base-case assumption has things like new-home sales on a year-over-year basis bottoming out in the latter part of 2008." But he cautioned that this was "an educated guess," pointing out that at the start of 2007, people had "what turned out to be far too optimistic expectations for the year."

As was the case last year, unexpected things could happen in '08, either economically or this time in the conforming, or non-subprime loan market, that would further weaken housing - "certainly, that's a possibility," he allowed - though conversely, "the economy might not turn out to be as lackluster as people are expecting, and maybe we start to see the mortgage market firm up sooner rather than later." Such a scenario of more positive signs is "not unreasonable - but there are no guarantees."

He said that in the meantime, more downgrades of homebuilders like D.R. Horton Inc., Toll Brothers Inc., Ryland Group Inc. and industry leader Lennar Corp. to junk - Fitch currently rates all in the BBB or BBB- area - are a possibility. At the same time, on the lower end of the spectrum, the ability of weaker names like Tousa Inc., Beazer Homes USA Inc. and WCI Communities Inc. to avoid bankruptcy will depend upon their being able to "manage to their [specific] situations as best they can - and forbearance on the part of their banks."

A trader said that "we'll have to keep a close eye" on the builders, and on the closely related building materials sector, "to see if there is any kind of turn in them."

The builders, he said, "will have to stop building, and let some supply run off. If rates stay low, maybe we'll see some resurgence of the homebuyer." For now, though, he counseled, "I do think there's value there - but I'm just not saying that now is the time to be buying them."

A tough year ahead

Looking at the overall market, he said that 2007 had been an "absolutely brutal" year full of abrupt reversals and "no real major conviction," particularly over the last five months of the year "after we crapped out in August." And 2008, he warned would be "difficult - again."

"We can't really get too geared up for [2008]. It seems like the overhang and the undertones that caused this uncertainty remain - and are probably more significant now."

The trader predicted returns of about 4% to 5%, with about a 3% default rate and 1% or 2% economic growth. Market players, he said, would have to be "more issuer-specific, understand your credit and do some extra legwork and check their amortization schedules and financing needs for the near term."

He said that "right at this moment, it's incredibly difficult" to foretell a "great outlook" for any particular sector. "Nothing really stands out."

Telecommunications would be relatively safe, he opined. On the downside, "the distressed market will increase in size, as it has for the last quarter."

It will also promises to be a rough road ahead for the carmakers, who "finally got their cost situation under control" in 2007 with new agreements by each of the Big Three with their unions to rein in burgeoning retiree healthcare costs - "only to run into consumers with tight purse strings." With the expansive and heavily incentive-driven holiday shopping time - when one might buy a new car as a pricy gift for someone special - now in the rearview mirror, "people will really be pulling in their horns. The consumer will be much quieter in the first half of the year."

A little bit of hope

At another desk, a trader projected that while 2007 would prove to be little more than "a breakeven year," in 2008 the economy "is going to be a little bit better than people think it is. There's a lot of fear and people are kind of sitting on their hands because they don't know when the next shoe is going to drop - but the Fed is in the process of cleaning the situation up as far as pumping a lot of liquidity into the system and helping to get the banking system moving again. So I'm relatively optimistic to neutral."

He projected that interest rates "will probably hold right about here with a 4.25% to 4% 10-year government bond. Spreads with the index trading at 500 basis points off are probably fairly priced to a little bit cheap, considering that right now you've got a 1% default rate and in a worst case scenario, you could get about a 4% default rate - which is pretty much what the market is pricing in already."

He said that high yield would likely return "anywhere from 4% to 6%, with probably a little price depreciation and a coupon that runs around 8%."

The trader said that he would "stay out" of cyclicals, although he suggested that "the autos are probably pretty fairly priced at this time, even though they're cyclical - they're solving some of their problems."

He said that he would "be in tune to go to the more defensive names, such as going to food," He would try to "stay away from the consumer," and particularly from the restaurants. A buying area might be telecom, "with Qwest [Communications Inc.] and some of those, they're improving."

Casinos a safe bet?

Curiously, even with economic sectors dependent on discretionary consumer spending seen likely to take it on the chin, one exception to the rule would seem to be the gaming sector.

Although it seems counterintuitive, several of the experts queried by Prospect News were of the opinion that even though cash- and debt-constrained consumers will cut back on spending that is not absolutely essential - that will not slow the roulette wheels or keep the dice from tumbling in places like Las Vegas, Atlantic City, Tunica, Miss., Connecticut and other markets with gambling operations.

J. Giordano's Featherston said that "the weird thing is that 'sin companies' always seem to fare best in slow times - people will always buy cigarettes, if not buy more cigarettes, if they're nervous about losing their jobs. They might buy more booze when they're concerned about the economy, or go out and play the lottery or [otherwise] gamble, whatever the case may be." He pointed out recent announcements of planned expansion from places like Connecticut to Kansas to Abu Dhabi by such big casino players as MGM Mirage, Harrah's Entertainment and Foxwoods. "They felt, even with the [economic] slowdown, that they don't think they're going to get clipped."

KDP's Penniman agreed, noting that "casinos have always been considered as somewhat defensive - we saw that after 9/11, when people said that nobody would go" to them, given the disruptions to air travel caused by the attacks, "but traffic was still strong. I think a lot of these casinos now are family destination resorts - and with the lower dollar, maybe you don't travel [abroad now], you go to a casino and bring your family with you, but I do think casinos have always been that way."

He said that for a while, "they were trading very, very tight and rich, and reflecting the fact that the market has widened out a bit, they were a little too rich, and have seen some pressure - but I think in general, an area where you don't expect to see significant credit deterioration would be the casinos."

Another factor boosting the sector is the unlikelihood of any unpleasant financial surprises suddenly popping up to stun investors, given the sector's great transparency - a function of the heavily regulated industry's close scrutiny by state regulators in Nevada, New Jersey and other jurisdictions.

"As a sector, casinos are something not as vulnerable to the economy as the other sectors," Penniman asserted.

A trader said that the gaming sector would likely be "okay" in 2008 - but "dicier than in the past."

Another trader, however, disagreed. "Look at the last quarter, or the last couple of months - [the casino 'win' figures] in Las Vegas or Atlantic City - everything is down. Trump [Entertainment Resorts Inc.] is down, the Borgata [joint venture of MGM Mirage and Boyd Gaming Inc.] is down. Tropicana [Entertainment LLC] is a mess," and recently had its New Jersey casino license renewal denied for alleged mismanagement.

He noted that there are always irresponsible people who "are not thinking prudently when times are good, and they're spending over their heads. They probably don't give a s**t when times are bad, until they run out of dough - but at some point, they're going to run out." But for most people, he said, "if you don't have enough money to pay your credit card bill and you have a family, you're not wasting two grand or five grand for a weekend playing craps. I would tend to shy away from gaming."

LBOs down but not out

Continuing the trend seen in 2006, much of the heat in the market's 2007 first half came from the proliferation of LBO deals, which in most cases both boosted the performance of the acquired company's existing bonds on the expectation that it would be taken out, and swelled new-issue statistics - but the mid-year credit crunch put a stop to that.

A notable story was that of United Rentals Inc., whose existing bonds soared in the summer on the news that Cerberus Capital Management LLC would acquire the big Greenwich, Conn.-based equipment rental company - but then fell in the fall when Cerberus pulled out due to its inability to line up the needed financing on reasonable terms. The bonds fell again in December when the Delaware state courts quashed United Rentals' legal effort to compel Cerberus to proceed with the LBO.

That's a cautionary tale for other potential LBO-minded acquirers - but KDP's Penniman said that there will still be LBO deals going forward in '08, although they will be "better deals [with] better structure, less leverage and lower prices. People were outbidding each other when you weren't paying a lot for the capital. If you didn't have maintenance tests and weren't worried about whether you could stay in compliance [with covenant requirements], you could afford to pay a lot."

The deals that didn't get done, he said, reflected market concerns that "these companies were over-leveraged in the environment that we now face."

Now, on the other hand, "you're likely to still see some deals - but not of the kind where you're going to be paying 9 or 10 times EBITDA, with low financing costs like we were seeing in May or June. The market finally said 'enough is enough, and we're not going to do it'."

Modest returns expected

Penniman said that it is "not hard to forecast that despite all of the gloom and doom, there will be better returns in 2008 than in 2007." In general, he said that the high yield market will likely return about 5% to 6%. "You're going to see spreads widen, and you're not going to earn your coupon."

However, he cautioned that "where you're structured in the [credit] landscape is going to be more important," with a lot of the anticipated rise in defaults expected to take place down in the lowest-rated paper, the CCCs.

"In general, they are likely to widen out and to see price pressures." But "if you're moving up the quality spectrum, you're going to get much better returns - better quality, less volatile and less risk adverse." He said that loans will likely do even better than bonds in the coming year, "so a combination of higher-quality bonds and loans probably will be earning much higher returns than the 5% - maybe the 6% or 7% range."

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