Lack of volume in junk sector forces bond traders to make money elsewhere, hope for turnaround

By Stephanie N. Rotondo

Portland, Ore., March 25 - In the wake of the turmoil facing the financial and housing sectors, bond trading volume in the distressed and high-yield arena has slowed to a crawl.

As a result, bond traders are turning away from the junk market and focusing their attention on areas where they believe there is still money to be made.

But there is not one specific sector that traders are turning to. At one shop, a trader said the focus has been on emerging markets and mergers and acquisitions, while another said mortgage- and asset-backed securities are where the action is. Yet another source said equities and options are monopolizing his time.

One distressed and high-yield analyst opined that the market was instead playing with credit default swap (CDS) trading.

"That's what it is," he said. "If you can do CDS, you can employ more leverage and take positions that can get you money."

Last summer's subprime mortgage meltdown and housing slump wreaked havoc on the marketplace. Financial institutions were posting huge writedowns, and homebuilders one by one seemed on the brink of bankruptcy.

The ensuing credit crunch put more restraints on the market, as companies looking for additional financing could not find it - or when they did, the terms were unfavorable.

But the damage was not localized. In fact, the market continues to reel from the experience. The recent troubles over at Bear Stearns Cos. are just one example of how the market is still trying to deal with the fallout.

"Over-exuberance in the housing market is the cause of it all," stated one market source.

As a result, fear has replaced optimism, and the junk bond sector has taken it on the chin. Investors, who are too scared to take a risk in the shaky economic environment, are backing away from anything that seems even remotely "iffy," and trading volume has therefore declined significantly.

With less liquidity to be seen, smaller shops seem to be hit the hardest, with many cutting their distressed and high-yield desks back, or in as in the case of one New England boutique shop, eliminating them altogether.

At one smaller firm, a junk bond trader said several colleagues who left his shop some weeks ago were not immediately replaced, although his firm does plan on hiring one person to help him out, since he picked up much of the slack when the vacancies occurred.

"Hopefully," he said, the new hire will come aboard "soon."

Even though the workload has increased, he said, he can't complain too much about it because "look at how many guys [in the industry] are out of work."

A lot of people "are getting crushed, as you'd imagine," he said. "So you don't want to [complain] about things, as long as you still have a job these days."

Investor attention difficult

One trader at a boutique shop said it has been hard to get investors to focus their energies.

"Some accounts are telling me they want to do business with me but they are very quiet," he said. "I think much of the business is with the super large funds, and Goldman [Sachs]. It's hard for small shops like mine to get [investors'] attention."

"It just feels very different," said another source. "I think people want to play their cards close to the vest. It is a generally uncertain time out there."

"There is a massive liquidity crunch," said one trader. And with all the LBOs and bank debt out there on bank balance sheets, still waiting to be distributed, "I don't know when all that stuff will free up.

"We are not getting paid to be creative," the trader added.

Still, big shops may not be immune to the troubles. Rumors abound that bigger names have cut jobs, particularly in their distressed and high-yield departments.

'Watching and waiting'

Some say the cutbacks are not based on "rational thought," but rather fear in a business that is not currently a guaranteed moneymaker. Others are taking a "waiting and watching" approach.

What, then, does the future hold for the junk arena if traders and investors alike are backing away from that market?

"The cash market will come back eventually," the analyst said. "Things will pick up as there become more issues with the CDS market."

"I think the market will improve, it just may take a while until distressed investors feel there is some stability in the market," a trader said.

"I am sure it will," said another trader when asked if he thought a turnaround was looming. "It always does."

Subprime resolution needed

Many believe that, in order for a turnaround to take place, the excess baggage of the subprime housing crisis needs to be unloaded.

"We need to get through all the ramifications caused by all that stuff," a source said.

But while most believe there will once again be good times in the junk sector, no one is clear on when the turnaround will occur.

"I don't see something snapping back to turn things around tomorrow," the source continued. "There is no rapid recovery."

"It will come back," the analyst added. "The underlying security [i.e. the bonds] is where the value is. When things turn around, the bond is where the value is."

Second half of '08, or '09, or '10?

One trader said he sees the turnaround coming in 2009 or perhaps even 2010 - unlike other market players who are looking to the second half of 2008 for some relief.

"There will be some [more] things that blow up," he said. "It needs to get worse. We need things that are just hanging around to disappear," he added, citing distressed names like Linens n' Things Inc. and Realogy Corp.

With no set timing for the turnaround, it seems patience is the only option.

"The remedy will take quite a while," a source said. "Time will heal everything. But it could be a while."

"Until we get a lot of pain, there is a lot of uncertainty," another trader surmised. "Nobody wants to do anything.

Still, "when it flushes, there is going to be a lot to do," he said.

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