Cautious look ahead in investment-grade bonds sees less risk, larger costs, fewer bookrunners

By Andrea Heisinger

New York, Sept. 29 - As the drama in the financial world continues to unfold, many in the investment-grade bond market are looking forward to a return to normalcy.

But the landscape they are hoping to return to may not be a familiar one of even a few weeks ago. With an array of mergers, buyouts and collapses since the beginning of September, the investment-grade sector is now looking vastly different.

And the new issue market has been effectively shut for the last month, save for a couple of brief windows that opened, allowing a few issuers at a time to squeeze in before the next negative news hit headlines.

All of these recent events have left investors and issuers alike wary of the market.

No one contacted by Prospect News was willing to venture a guess as to how long it would be before a sense of normalcy is felt in the corporate bond market.

"Everyone wants to get back to doing what we do," a source said in the optimistic days after the government's bailout plan was announced. "We're tired of watching the news and reading all of the headlines."

In the past two months the market has weathered the downfall of mortgage lenders Fannie Mae and Freddie Mac, and investment bank Lehman Brothers, as well as commercial bank Washington Mutual. Then there was the failure and subsequent government bailout of American International Group.

A buyout was facilitated for Bear Stearns by JPMorgan and Merrill Lynch by Banc of America, and Goldman Sachs and Morgan Stanley opted to become bank holding companies. And Monday it was announced the banking operations of Wachovia Corp. would be sold to Citigroup.

Quality names to lead recovery

"Our markets are definitely wounded," a source said. "We need to heal in a sequential fashion."

This means quality names need to issue, and spreads need to tighten to entice more - and lower-rated -issuers into the market

"We need better names brought and they need to tighten in the secondary," a source said.

Still, the government's bailout plan of an estimated $700 billion to buy distressed mortgages had offered the largest ray of hope - before it foundered.

"We're all kind of hoping we can put this mess behind us, at least in the short term," a source said before the House of Representatives voted down the proposal Monday.

Many say the landscape of the investment-grade market is currently unclear, especially without many new issues to show any effects of the sudden and vast changes.

The loss of names like Lehman Brothers and Merrill Lynch as bookrunners has not been felt particularly hard so far, sources said.

"I don't think it's going to affect the volume [of issues]," a source said. "It's not a function of the number of firms, it's how [issuers] perceive the macro market."

The type of issues being done in the past month have been either five- or 10-year maturities, and no one is going to be doing 30-year or longer issues any times soon, a source said.

Those investing in the new issues could also change.

"That's still something to figure out," a source said. During the volatility of late August and early September, many investors started looking at real money market management, he said, and gave the example that if the investor has 30% to spend in investment grade they're going to look at more reallocation toward safer assets.

Lehman bankruptcy tarnishes market

The corporate bond market has become a risky place to invest and issue, with high new issue premiums and other factors.

This was highlighted recently when a report from JPMorgan stated that Lehman Brothers left more than $100 billion in debt after its bankruptcy filing, and a default on its bonds wounded faith in the investment-grade market.

Default risk in Lehman and other financial names has driven up spreads in recent weeks, which is another thing the investment-grade market must overcome.

It will likely be a "very long time" before spreads recover to the levels they were in 2006 and 2007, a source said.

"I look back and wonder how spreads were that low," he said.

At the same time, he acknowledged the risk corporate bonds carry, and said they need to be priced accordingly, even in the secondary.

Many in the investment-grade market are in agreement that it will be a slow road to recovery and winning back both investor and issuer trust.

Staying safe

For the time being everyone will be playing it safe with smaller issues and the companies will simply have to swallow the cost associated with a deal.

"We're seeing like 100 basis points on good names," a source said, referring to an issue from Caterpillar Financial Services Corp. priced during the recent meltdown.

Issues will likely be more carefully thought out and based on perceived risk. The so-called opportunistic issuers that take advantage of good market conditions may be a thing of the past.

"That's a dying if not extinct breed," a source said. "The cost of debt is a lot more."

The tolerance for more leverage in this environment is greatly reduced, a source said, predicting five to 10 years of slower economic growth ahead.

Big backlog waiting

Despite the caution of many, a backlog has been building for more than a month meaning some issuers are becoming impatient to price a deal.

"Some have been waiting since August," a source said. "We really have a limited time until the end of the year. People were planning to get a lot of it out of the way this month, but that's not going to happen."

At the end of August it was predicted September would see $80 billion to $100 billion in new issues, as many companies were waiting until after Labor Day to price a deal.

With market conditions markedly worse than expected, a small fraction of that was priced.

"Things are still unfolding, and it's really hard to look too far into the future," a source said.

Until market volume is back to normal, it will also be hard to measure the impact of the loss of bookrunners like Lehman, he said, adding that it's unlikely smaller firms will be elevated to that big-name level.

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