Seneca's Haag 'defensively bullish' about high yield prospects, sees busy new issuance ahead

By Paul Deckelman

New York, Sept. 27 - The high yield market is doing quite well right now and should continue to do alright in the near-term - although technical factors, including expected strong new issuance in the remainder of the year, could play a role and are a cause for caution. And today's easy liquidity "could come back to haunt us" several years down the road.

That is the view of portfolio manager Tom Haag, who runs the high-yield portion of Seneca Capital Management LLC, a San Francisco-based investment company that manages some $12 billion in investment-grade and high yield fixed-income, and equity products. Seneca's High-Quality High Yield fund has composite assets of about $288 million as of the end of last year (not counting carveouts from larger accounts), against a company-wide asset base at that time of over $10 billion.

The junk-bond market so far this year "has pretty well crackled," Haag said on a conference call with investors and journalists Wednesday, up around 7% for the year according to the Lehman Brothers High Yield Index.

High yield, said Haag, is "obviously" the top-performing fixed-income asset class in the United States, "and in fact is beating some of the major equity indices as well."

Lower-quality issues outperform

So far, he pointed out, the market has been "somewhat surprisingly" dominated by the lowest quality reaches of the high yield universe. "Some of the sectors that have done well this year are clearly the ones that were the lowest quality, highest yielding as the year began, notably the automotive sector, which continues to be very topical."

He said the firm's strategists "didn't quite think [the lower quality segment] would be as strong as it was - but that's all good for us, we'll take what we can get."

Seneca is trying to take advantage of the trend. Despite the official name of the fund - "High-Quality High Yield" - true high-quality credits, rated Baa and above, make up only 8.4% of the portfolio's weighting. The largest credit quality grouping is the fairly lower quality B credits, which account for 53.1% of its holdings, while the medium quality Ba rated names weigh in at 36%. Truly low quality names, with ratings less than a B, only account for 2.1% of its holdings.

19% consumer cyclicals

Broken down on a broad-sector basis, consumer cyclical issues, which include the autos, make up about 19% of the portfolio, one of the largest concentrations of any area. Other areas where Seneca is heavily weighted include communications (20.6%), capital goods (10.75%), utilities (10.2%), consumer non-cyclical names (9.7%) and basic industry (9.3%).

Haag said that more recently, with the slowing economy and the Fed policy shift de-emphasizing interest rate hikes and interest rates accordingly falling a little, "it has allowed the BB sector to start to achieve some positive performance. So net-net, the more recent performance in the market looks more normalized."

Conversely, the portfolio manager noted, "some of the poorer-performing sectors have been the highest-quality sectors with the lowest yield, but also, any industries that are exposed to the housing market and to the housing industry indirectly have had a poor year."

Sees 5% house price drop

Seneca's chief strategist, Max Bublitz, said during the presentation that the company's view on housing is that "in the next 12 to 15 months, we could see an additional 5% correction [in house prices] nationally, perhaps a little bit more so on a regional basis, based on how consumers respond. Over the next five years, we see house prices flat on a real basis, ex-inflation."

Bublitz said that the Fed "is done" raising interest rates, and the economy now appears poised for a soft landing, rather than a hard one, cushioned by recently lower interest rates and oil prices, as well as by tame inflation rates - 3.25% to 3.5% for the '06 second half, trending down into the 2s by next year - and good consumer confidence levels.

Fundamentals, technicals help junk

Haag said that "one of the reasons why high yield has done well and why credit [in general] continues to do well is certainly, the solid fundamentals in the domestic economy are helping a lot, even though they are poised to perhaps fall below 3% on a GDP basis over the next number of quarters."

He said that Seneca's views is that "normally, anything north of 2% is fairly sanguine for the high yield market, and that's what we anticipate for the rest of this year and going into next year, to maintain GDP above 2%."

Beyond fundamentals, technical factors, he said, will play a key role in market performance, including simple supply and demand economics.

So far this year, insurance companies and pension funds reaching for yield have been buying up existing bonds, and the supply of outstanding junk has been further reduced by "north of $20 billion" by companies taking out outstanding bonds by tendering for them, either in order to clean up their balance sheets or as part of leveraged buyouts or other acquisition transactions.

Also sopping up a lot of bonds, he said, has been the need of bondholders to reinvest coupon income.

"A significant amount of coupon income is generated in the high yield market," Haag said. "Again, it doesn't sound that dramatic - but the high yield market is substantially larger than it has been over the past few years, and as it continues to grow, the coupon income needs to be reinvested, and that definitely fuels demand in the market."

Further dampening the amount of bonds available - thus pushing prices up for those that are - were such factors as a fall-off in the number and overall quantity of fallen angels that make their way into high yield from investment-grade territory, as well as less than anticipated new supply.

Lots of issuance ahead

New issuance "has not been quite as large as people anticipated," Haag said, and "demand dollars have definitely outstripped new supply."

However, he added, "the fourth quarter and the first quarter of next year looks to be a very large calendar."

Technical factors such as supply-and-demand considerations provide "some reason for concern" in the near term, the portfolio manager said.

He estimates that there will be "no less than $30 billion [of new issuance] going into the last three to four months of the year, and said that there might even be as much as $50 billion of new paper.

"We're just starting to begin that surge right now. We think that will provide for some technical volatility in the market, again, more short-term in nature, but volatility none the less."

Besides the anticipated junk issuance, "you have some of these very large deals coming, and not just in 'high yield land,' but also touching on bank loans," where he said there might be as much as $70 billion to claim the attentions of investors over the next few months. "So between those two, you have $120 billion to $130 billion of new issuance."

On the bank loan side, he continued, "with the large deals coming from HCA [Corp.] and KMI [Kinder Morgan Inc.] and perhaps some others, there will be four or five deals on the bank market that could be north of $5 billion in the fourth quarter, and previously, there's only been one loan larger than that in the past, Georgia Pacific [Corp.]. Typically, with these larger deals, we anticipate that high yield bond players will have to participate in the loan market to get those deals done, so that will be another component of supply that will be somewhat interesting to see how it unfolds."

LBOs, M&A rolling on

Haag sees a continuation of the trend towards LBOs and other merger and acquisition activity that has been a major story in junkland so far this year, and for the moment, that's a good thing.

"For the high-yield market, M&A more often than not provides for opportunities, because of the fact that high-yield companies have [bond] covenants. So for a lot of LBOs, or other major recaps of the balance sheet, high yield companies' covenants usually provide for the opportunity - the bonds get taken out and tendered."

With that trend slated to continue, and even given the volatility he expects in the market, "high yield will still continue to grind out positive returns as the year moves on."

There are some warning flags further down the road - particularly the possibility of more defaults.

1.5% default rate possible

Haag said that right now, default rates remain at historically low levels, "more or less sub-2%" - which he termed "an obvious reason for the continuation of the strong high yield market" - and they promise to get even lower before the year is through. He pointed out that when the ratings agencies calculate their default rates, they compute them on a last-12-months basis, averaging the rates from the current month and those of the previous 11. As each new month occurs, the oldest year-ago month is dropped from the calculations.

"Last in year in the fourth quarter, we had a large default of Calpine [Corp.], we had Northwest [Airlines Corp.], we had Delphi [Corp.], as well as a few smaller ones. Those are all rolling off in this quarter, so it's possible that by the measures we've seen that the default rate could go as low as 1.5 % in the fourth quarter due to that dynamic," although he said that would be conditioned on the "very unlikely scenario of not seeing any major defaults in the fourth quarter right now."

Seneca expects the default rate to remain "quite low throughout 2007, probably not touching 3% until late in the year, which is still well below the mid-4% long-term default average."

However, beyond that point, there could be trouble.

Default problems ahead

Haag noted that traditionally, the time of peak opportunity for defaults is roughly three years after debt is issued. The cushion of borrowed money has usually been all spent by then, leaving the company having to now service that debt out of funds generated from operations.

He noted the "the strong liquidity being provided by both the credit side and the private equity side" right now, allowing for "a lot more companies to get financed in the near term, and as that happens, the default cycle, which we don't expect to spike until 2008 or '09 could become quote large. The more companies that get financed in this time cycle, the more opportunities there will be for default later. . . So that's about in an '08 time frame when we start to get more concerned."

LBOs especially, he said "tend to be higher-risk and have a higher quotient of default when they do hit their peak default opportunity, so that will be something that happens in the next three or four years.

"M&A, as well as other equity-friendly events, are going to cause problems down the road as these companies finance now with the easy money - but what will happen in a few years when there's no longer easy money?"

Haag said that Seneca maintains "a high-quality approach in the course of an economic cycle," and is "doing no differently now. We think that the fact that we are on the back side of a cycle augers for probably moving up in quality as time goes on.

"We're defensively bullish in the sense that we will look to put more money to work as we see some volatility - but it will probably be in the higher-quality component of the high-yield market."

Overall, he concluded, "from our standpoint, the credit cycle is still quite solid. Near-term technicals could cause problems. In the intermediate term, we think it will be OK, and longer term, we're somewhat concerned with the excess liquidity that the market has right now."

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