Outlook 2008: Primary seen falling short of strong 2007; many questions over year's prospects

By Paul A. Harris

St. Louis, Dec. 31 - The 2007 primary market turned out a "near miss" amount of issuance, falling just short of an all-time high - but 2008 is likely to fall notably short of that mark, sources said.

The year's total on Dec. 28 was $155.8 billion, less than $1 billion under 2006's record-setting issuance of $156.6 billion.

One high yield syndicates official characterized 2007 as a "front-loaded" year, in terms of issuance, meaning that most of the business that cleared did so prior to the midpoint. Prospect News data bears that out, with Jan. 1 to June 30 producing $108.3 billion, while the July 1 to year-end period produced just $47.6 billion.

Records nevertheless fell during 2007.

On March 14 Freeport-McMoRan Copper & Gold Inc. placed record-breaking issuance of $6 billion, the most amount of issuance from a single issuer in a single day, to that point.

The deal included a record-setting $3.5 billion tranche of 8 3/8% senior notes due April 1, 2017.

That single tranche-record held, but on Oct. 24 the company's record for overall issuance amount fell when TXU Corp. priced $7.5 billion in three tranches.

Meanwhile Northwest Pipeline Corp. walked away with the year's lowest cash coupon when it priced its 5.95% senior notes due April 15, 2017 on April 2.

And Blaze Recycling & Metals, LLC/Blaze Finance Corp. garnered 2007's highest cash coupon, 16½%, with a placement of senior subordinated notes due Jan. 15, 2013 on June 22.

New household word

The dramatic downturn in volume during the second half of the year hinged on difficulties in the credit markets stemming from losses tied to subprime mortgages which spilled over into high yield bonds and leveraged loans. Investors' appetites for risk dwindled and spreads, according to one high yield investor, reached four-year wides.

The word "subprime," which crawled from the murk during Spring 2007, had become an utterly familiar term in the leveraged markets by high summer.

In the high yield and leveraged loan markets subprime-related spread widening gave rise to a new phenomenon known as the "LBO-related risk overhang." Leveraged buyout financings that were aggressively bid by underwriters remained on those underwriters' books as funded bridge loans backed by bonds and loans.

The hung bridges were capped at interest rates in which - partly owing to subprime-related spread widening - investors had little interest.

This risk overhang, now known as "the backlog," is estimated to represent between $200 billion and $230 billion of funded bridges and pending LBO transactions. Of that amount $50 billion to $80 billion is believed to be comprised of high yield debt.

It loomed large as market sources set out their forecasts for 2008 junk issuance.

However as the fallout from the subprime mess widened - and continues to widen at this writing - it did so against a backdrop of historically low defaults. Standard & Poor's stated that in November the global junk default rate hit a new 25-year low at 0.74%.

When conversation turns to the extremely low high yield default rates reported at the close of 2007, however, market watchers almost reflexively pointed out that mathematics, alone, dictate that defaults are about as low as they can go.

"Defaults can only move in one direction, now," a money manager stated during mid-December, expressing an opinion which enjoyed virtually universal assent among the sources who communicated with Prospect News as this 2008 market outlook was being prepared.

Reduced issuance for 2008

Sources from high yield syndicates, all of whom spoke on background, generally agreed that 2008 will see a significantly reduced amount of issuance, compared to the totals generated in 2006 and 2007.

Some separated expected issuance tied to non-LBO related deals, which have lately come to be known in the jargon as "corporate" deals, from issuance related to the backlog.

Others combined the two.

Given this caveat, the forecasts ranged from a low of $90 billion to a high of $160 billion.

Most forecasts came toward the middle of that range.

One investment banker, pressed for a forecast, became somewhat testy, and shot back: "You tell me what the economy is going to do, and we'll tell you how much issuance can be expected."

This was the most dramatic manifestation of a recurring theme: extended weakness in the U.S. economy and/or a dramatic spike in defaults, could have an eroding effect on issuance that is not apparent as the year gets underway.

The sell-sider who rolled out the highest forecast, the "$160 billion area," specified that the number does include the backlog. Non-backlog related issuance, the source added, is expected to come in the $120 billion area.

"If conditions are good, and the backlog starts coming out, those numbers could move up," the investment banker added.

Another primary market source, who estimated that the backlog at year end was $225 billion - $150 billion of bank debt and $75 billion of high yield - expects the banks to work through all of the backlog in 2008, on way or another.

This source anticipates total high yield issuance of $150 billion, with a 50-50 split between new bonds and the backlog.

The syndicate official who proferred the lowest number, $90 billion, specified that such an amount would be the product of dire circumstances in the economy, and increasing risk aversion on the part of investors.

Absent such deterioration, this official expects $100 billion to $110 billion, and added: "That would be a pretty solid situation."

An official from the high yield syndicate desk of a different investment bank forecast $110 billion of issuance for the year ahead.

This sell-sider was hardly alone in listing factors likely to constrict economic growth in 2008: reduced consumer spending, the housing overhang and a chance of recession.

"I think people are going to have trouble finding capital," the banker said.

One senior high yield syndicate official looks for 2008 issuance to be 25% to 30% lower than that of 2007, adding that 2008 could see between $110 billion and $125 billion.

Hot and cold

Another investment bank projects between $130 and $140 billion of dollar-denominated new issue supply in 2008, a 10% decline from 2007.

This source and others expect 2008 issuance to surface in bursts which will alternate with periods of extreme quiet in the primary market.

Another sell sider, who was seeing things in a similar light, said: "We expect a lot of volatility.

"There will be periods during which [the high yield primary market] will give the appearance of a hot market, when people want to add risk.

"And there will be periods during which the market will just shut down, as it pretty much did in the second half of 2007."

This source looks for $140 billion of global issuance, including exchange-adjusted amounts of euro-denominated and sterling-denominated new issues.

This source's forecast includes some of the backlog.

European outlook gloomy

The decline in issuance during the second half of 2007, which was dramatic in the U.S. market, was nearly absolute in the European market.

One senior high yield syndicate official in London recalled that the last European issuer to place a sizable amount of issuance in the high yield market was French real estate developer Akerys Holdings SA which priced a €300 million issue of three-month Euribor plus 325 basis points senior floating-rate notes due 2014 (Ba3/BB-) at par on July 16.

This source drew several distinctions between the U.S. market and the European market.

First of all, the official recounted, the U.S. had a "huge backlog" of hung LBO deals which the investment banks "had more reasons to try to move quickly at [original issue discounts] for reasons unique to the U.S. market, not all directly high yield-related."

The source added that the European LBO backlog, as far as high yield-related bridge loans are concerned, is almost non-existent.

"Moreover, the European banks do not as aggressively mark-to-market, and generally are in better shape than their U.S. peers," the senior syndicate official asserted.

"Hence, the LBO-related high yield market in Europe has not taken off because there is no forward calendar to speak of."

Also absent from the European market during the second half of 2007, were drive-by deals from higher tier corporate issuers which helped to reopen the U.S. market.

"A combination of the high quality of the issuers, the fact they were not LBO's, and the presence of proxy pricing in the form of existing bonds meant companies could easily issue in modest size in the U.S.," the official said.

The corporate high yield secondary market in Europe is much less deep, and the number of issuers which could even take advantage of such circumstances, again, is a fraction of the U.S. market, the official said.

"There is virtually no forward calendar for European corporates, either, so once again, there is no real catalyst to re-start the market in Europe."

This official also said that, in a more marginal way, mega-high yield issues "done from what I would call the more desperate issuers in the U.S., usually at 12%-plus coupons and in modest sizes," got things rolling in the U.S. primary.

"Again, these sorts of issuers just don't exist - yet - in Europe.

"So the confluence of these factors does not bode well for the European high yield market, at least currently."

The senior syndicate official in London also said that the sell-side is not eager to see a repeat of the Melrose Resources plc €250 million offering of eight-year senior subordinated notes (CCC+) which was postponed in early November due to market conditions.

In addition, equity sponsors in Europe have been big users of the floating-rate notes market, and that market appears to be tremendously curbed in the present environment, with the effective sidelining of CDOs and "new money" hedge funds.

"As a result, private equity sponsors in Europe are going to have to reorient themselves to fixed-rate debt, which they have found unpleasant in the past. And already there to fill this gap is the mezzanine market in Europe, which is stepping up again on new issues."

This source expects little issuance in the first quarter of 2008, but looks for overall 2008 issuance to be on a par with that of 2007, and lower than 2006.

According to Prospect News data 2007 euro-denominated issuance amounted to €22.6 billion; 2006 euro-denominated issuance was €29.6 billion.

Another high yield syndicate official in London looks for issuance of €20 billion, which could improve to €30 billion if conditions improve.

This source cited the following reasons behind the forecast:

• The forward calendar in Europe is very small compared to that of the U.S. market;

• There is very limited to no LBO backlog in Europe;

• Investors have been more focused inwardly in the last few months;

• All opportunistic issuers have vanished as current new issue levels are not attractive.

One factor that should kindle issuance, the official added, is companies that need to refinance during the coming year.

The backlog

Discussion of the backlog tended to generate lively discussion among sell-side sources.

Most estimates of its present size come with a caveat: "What, exactly, should be included in the count?"

One market source, speaking in mid-December, cited the Lehman Brothers Credit Report 2007 Recap, asserting that the banks have whittled away the high yield portion of the backlog to approximately $81 billion from a Summer 2007 peak of $95 billion.

Of that $81 billion, $21 billion is comprised of funded bridges and $60 billion of pending transactions.

Lehman expects that $81 billion of high yield backlog to result in $50 billion to $60 billion of new junk bond issuance, the source said.

Meanwhile a high yield syndicate official, pressed for an estimate of the size of the backlog, simply asserted: "You have to define it.

"Are the deals that were structured after Labor Day part of the overhang?

"Or is it just the stuff that was structured before July 4 and hasn't sold yet?

"It's a hard number to track. There is a piece of the ServiceMaster bridge out there. It's free to trade. It's quoted off the desk.

"Does that count as overhang?"

Among the "LBO dividend deals" that placed amounts of risk during October and November, this official counts TXU, Alltel and First Data Corp.

"Biomet technically priced, although it doesn't show up as LBO bonds, but I think everyone would say it was placed.

"Everyone has their own view of the risk overhang," the source summed up.

"It's not as cut and dried as it was on Labor Day."

This source and others told Prospect News that obviously the hung LBO risk will continue to loom large in the new issue market during 2008.

"It's a big visible supply, so it will have an impact.

"There has been a repricing of risk, and it has been favorable to the buyside. Partly it's overhung deals. And partly it's new supply. And partly it's that the banks have had to unload risk.

"And there are some fresh LBOs that are set to go," the banker asserted.

"There is one in January. And we have visibility on another one for April, pending regulatory approval.

"The bridge caps are well wide of where the existing crop was."

More preferreds

A mutual fund money manager whose purview includes high yield bonds told Prospect News during mid-December that the junk accounts will undoubtedly take interest in an expected parade of double-A rated preferred stock deals, expected to price with fixed-rate dividends north of 8% in 2008.

This buy-sider pointed to late November's $6 billion preferred sale from Freddie Mac, with an 8 3/8% fixed-rate dividend for the first five years.

High-yield accounts took part in the deal.

The source also mentioned the early December $7 billion issue of Fannie Mae perpetual preferreds with a three-year fixed dividend of 8¼%.

"In the case of Freddie and Fannie, they are both perpetual preferreds, which are a little different from a high-yield bond which has a coupon, a yield and a maturity," the investor noted.

"But when our head of investments asked me what I thought of it I said 'What's to think? One has an 8¼% coupon, the other has an 8 3/8% coupon. It's AA nominally rated and government sanctioned. That's all you need to know.'"

The buy-sider said that these AA rated preferreds, paying north of 8%, should help to keep pressure on high yield spreads.

"That's not a bad thing because it keeps all high yield a little cheaper than it would otherwise be," the source added.

The technical picture

Sources on both the buy-side and the sell-side anticipate an ongoing bid for high-yield paper in 2008.

There is broad agreement, however, that the amounts of cash chasing junk bonds won't be nearly as massive as those at play during the winter and spring of 2007.

Nor are the richly priced deals of that period likely to reappear anytime soon, sources say.

Available information regarding the liquidity of the high yield mutual funds has been mixed through most of 2007.

AMG Data Services reported a $150.5 million outflow from high yield mutual funds for the week ending Dec. 26, according to market sources, who added that at the conclusion of the last full week of 2007 year-to-date flows among funds which report to AMG on a weekly basis stood at negative $2.75 billion, with only two market sessions remaining in the year.

Meanwhile the funds that report on a monthly basis saw inflows of $6.59 billion for the year to Dec. 26.

Hence at the Dec. 26 close, year-to-date aggregate flows, which tally the flows of both the weekly reporting and monthly reporting funds, remained squarely in the black at $3.84 billion.

Looking beyond the mutual funds, one market observer said that, although spreads are apt to become more attractive during 2008, pension funds are unlikely to meaningfully increase their allocations to junk, especially in light of forecasts for an economic downturn.

This same source said that hedge funds, which provided massive liquidity to the market during the first half of 2007, are unlikely to have as dramatic a role in 2008 due to leverage constraints.

One hedge fund money manager, however, is looking for continued activity in the primary market even if there is a meaningful slowdown in the U.S. economy because of the massive amount of cash that materializes in the form of coupon payments, and a notable amount of refinancing which needs to be done through the course of the year.

Michael Reiner, high yield strategist for Bear Stearns, told Prospect News that for 2008 there are approximately $50 billion in coupon payments and $5 billion in principal flows in the Bear Stearns High Yield Index.

The fundamental picture

As to the macroeconomic setting for the 2008 junk market, forecasts from sources in the big investment banks, which continue to labor with a bond and bank loan backlog estimated to be well north of $200 billion, were, perhaps understandably, somewhat gloomy.

On the other hand the buy-side, anticipating cheaper paper and greater leverage with respect to pricing, tended to be more upbeat.

Most of the sell-siders who spoke to Prospect News expect the housing market to continue to weigh upon the U.S. economy.

A few said that the economy could possibly dip into recession.

As to the above-mentioned default rate, which ended 2007 at a 25-year low well south of 1.0%, there is an almost universal expectation that 2008 will see defaults do an about-face and, because of a slowing economy and tighter capital, begin a northward trek.

One market source cited JP Morgan's 2008 High Yield Outlook and Strategy, which forecasts that defaults will rise to 2¼% in the coming year.

Nevertheless, some sources are looking for returns in the mid-single digits during 2008.

A portfolio manager whose focus includes junk bonds looks for high yield to do "pretty good, on a return basis if not an absolute basis.

"Yield spreads have widened out to over 600 basis points on the Bear Stearns index, whereas the long-term average is closer to 500," the buy-sider continued.

"The reason is that short Treasury rates are going to remain low.

"The Fed seems committed to helping the financial institutions get over the hump on subprime. So there will be plenty of liquidity around.

"I think the economy will begin to re-accelerate. I don't think we'll go into a recession. I think we will have single-digit growth.

"And by late Spring and early Summer there will be signs that the economy is ready to accelerate.

"That's a very positive backdrop for high yield."

This portfolio manager added that there is a chance that high yield will generate a total return in 2008 approximately equaling the coupon of high yield bonds - "in other words, well above the risk-free rate.

"You may have modest capital appreciation if the economy looks as though it's stabilizing, and if Treasury rates are stable to moving up," the investor said.

"In that scenario you should see high yield spreads narrow from above average to about average.

"So if you think that the 10-year Treasury is going to shake out around 4.0%, and if you can get 400 basis points to 500 basis points in very good quality credits, you are looking at a range of 7% to 10% of investible bonds in a portfolio, taking you pretty close to equities."

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