Advantage Data sees junk confidence reborn, but seeks market reforms

By Paul Deckelman

New York, June 10 -- The high-yield market has taken its lumps over the past year, but now, "we believe there is a rebirth of confidence in the high-yield market," the research chief for Advantage Data Inc. declared on Wednesday. The company's founder and president meanwhile called for more transparency and regulatory oversight in the sometimes murky world of high-stakes derivatives trading.

Speaking before the New York Society of Security Analysts' 19th Annual High Yield Bond Conference, Michael Franklin Brown, the head of research for the Boston-based financial market research firm, paraphrased White House chief economic advisor Lawrence H. Summers in saying that the high-yield market had shown "an excess of fear" - but he added that recent developments indicate that the market psychology had turned around.

Inflows power new-deal comeback

Brown pointed to a number of recent phenomena indicating a market resurgence, including the pickup in new issuance and the flood of high yield mutual fund inflows - a key barometer of overall junk market liquidity trends - as evidenced in statistics compiled by AMG Data Services and EPFR Global. He noted that the former service has calculated cumulative inflows of some $8.2 billion of capital into the funds over the last 12 weeks, while the latter, which includes money coming into some non-U.S.-domiciled funds as well as domestic funds, projects a $9.95 billion cumulative inflow in that timeframe.

Brown said that this year's sustained cash inflows - so far in 2009, the funds have only shown outflows in three weeks - have "helped the market rebound from the 25%-plus losses in '08."

The flow of money coming in has been a key driver in the new-deal revival, after the primary sphere had, he said, fallen to "essentially a non-existent level on a weekly basis" back in October and November.

"People thought that this might turn into a longer phenomenon than was expected, but as time went on, we saw a very different scenario," with new issuance starting slow and then coming on strong as the spring wore on, with "a significant amount of new issuance" since then, Brown said.

He also noted other statistical indicators pointing to junk's recent resurrection, including the sharp rebound since the nadir late last year in the widely followed Merrill Lynch High Yield Master II Index; as of the close of trading on Tuesday, the Master II was boasting an astounding year-to-date return of just under 29%.

Even as the index was in freefall last autumn, there had also been a corresponding "extreme" spike in yield-to-worst levels, some of which were "sky high," but as market performance improved, those began to come down from their peaks after the start of the new year.

Despite a smaller, but renewed rise in yields at one point in the early spring, as the rally temporarily hit a dead spot, these have since turned back downward and have now declined "significantly" from their peaks.

'January Effect' versus Obama?

"Right after the first of the year, things started to pick up."

Brown asked rhetorically whether "it was the 'January Effect', or perhaps new leadership in Washington?

"Whatever side of the political fence you are on, or whatever you feel the cause is, it can't be denied that there was a change in psychology" right after the first of the year.

The evidence, particularly the yield decline, "is a clear sign that things have shifted in terms of sentiment."

If anything, with market psychology having turned, Brown suggested that now "we have to be mindful of an overshoot of sentiment in the other direction - an excess of optimism. In fact, the high-yield market may be getting a little bit ahead of itself at this point."

Looking at various statistical measures, the Advantage Data research chief cited the rise in default rates as a measure of the distress the junk market has been through, with the 15.4% peak in that statistic reached during the depths of the Great Depression in 1933 as the baseline against which the current default surge is being measured.

Brown noted that current projections for 2010 call for default rates anywhere between at least 14% and in a worst-case scenario as much as 16% to 18%, beating the 1933 benchmark.

But even with anticipated rates at or near such historic highs, Brown asserted, "I personally don't think defaults are going to bring down the high-yield market, nor do I really feel they're going to derail the resurgence of confidence."

Brown compared the current economic downturn to prior periods of market turmoil, such as 1929-1933, the 1987 stock market crash, and the period of late 2001 following the 9/11 attacks.

While the 1987 dislocation proved to be relatively short-lived - equities regained their full pre-crash value within two years - Brown suggested that the rebound now will be "more rounded, and more restrained." He pointed out the close correlation, historically, between the upward and downward zigs and zags of the Merrill Lynch junk index and those of the Dow Jones Industrial Average, from the time junk bonds began to emerge in a major way during the Michael Milken era in the 1980s right up to the present. While the Dow spiked upward before both the 1987 and 2008 crashes more quickly than junk had, in the aftermath of each market disruption, the two market measures have been much more in sync.

The road ahead

Looking ahead, Advantage Data believes that high-yield bond spreads versus comparable Treasuries, which have narrowed solidly since hitting their wides late last year, will most likely tighten through 2010, with peak levels trending downward. Brown projected that under a second scenario, yields may show another secondary rise, such as occurred in March, but such additional peaks would probably be limited.

The worst-case possibility of a "near-term successive shock to the global markets" that could cause bond yields to spike even further, he said, is "much less likely."

He also said that "one reason why I think the high yield market will stay pretty robust for a while" is that Treasuries will struggle. "They're basically in a funk," due to over-supply stemming from heavy recent issuance to fund Washington's many bailouts, and market inflation concerns.

He noted that "even [Pimco Total Return Fund manager] Bill Gross has lightened up on Treasuries," a sign of the lessened attractiveness of the government paper.

On the other hand, Brown concluded, "we believe the high-yield market will offer a lot of opportunities for investors seeking yields."

A call for reform

Also speaking at the conference was Brown's Advantage Data colleague, Rene Robert, the company's founder and president, making what he called "the case for reform" in the capital markets, where blame for much of the damage last year and this has been laid upon financial firms pursuing strategies of maximizing profits by making risky, complex bets on frequently opaque and obscure derivative securities.

Robert said that back in the beginnings of the junk market it was largely controlled by its founding father, Michael Milken, "and today, similarly, credit default swap prices, identifiers, trading and documentation are tightly controlled by a consortium of the biggest banks. Products have changed - but secrecy has not."

Calling an implied comparison between what he termed the credit markets' "legendary infatuation with secrecy and complexity to obscure and confound" and the secretive back-room machinations worthy of characters from The Sopranos or The Godfather "not wholly inaccurate," Robert demanded "why does it take a Ph.D. in math or physics to properly value some securities? My answer, very simply, is: if you are the only person who can properly value a security, you will more likely make extraordinary profits in secondary trading."

While acknowledging that credit derivatives and similar instruments have a place in the financial world. Robert said that even before last year's market meltdown, alarms about potential troubles were being raised, but "the problem was seemingly too big for any one person, institution or even country to tackle," causing industry groups and regulators alike to look away for fear of driving business in the internationally traded securities to other markets.

"If anything can be learned from events of the last two years," he proclaimed, "it is that poor infrastructure in critical markets are eventually bound to lead to disaster. Transparency and regulatory oversight" in the derivatives market "are desperately needed."

Absent such reforms, he warned, "the next time Wall Street comes apart - and it will happen again - the U.S. government and taxpayers may not offer the same kind of support that they have" this time around.

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