Outlook 2012: Junk secondary still seen attractive after 'split personality' in 2011

By Paul Deckelman

New York, Dec. 30 - The novelist Charles Dickens famously wrote that "It was the best of times, it was the worst of times" in A Tale of Two Cities, and looking back at 2011, some players in the high-yield secondary arena were saying that this past year was a tale of two markets.

There was the robust first half of the year, characterized by solid performance and busy new issuance, coasting on the momentum carried over from an unexpectedly strong 2010.

Then in the second half, while nobody exactly went to the guillotine, the nascent rally got cut off at the knees by a confluence of macroeconomic forces, including the rapidly metastasizing European sovereign debt situation and the political kabuki dance being played out in Washington over raising the U.S. debt ceiling, and the larger question of how to tackle that burgeoning mountain of government I.O.U.s.

Amid uncertainty and market volatility following the first-ever downgrade of the U.S.' formerly sterling AAA rating on the one hand and the deepening European debt debacle on the other, the junk market coughed up its early gains, actually fell into the red for a while, and then staggered out of the hole, trying gamely to mount a comeback.

Junkbondland finished the year on rubbery legs but was still standing, having actually strung together some decent primary activity and improved secondary performance as the year drew to a close, helped by some mild indicators that the economy might be improving - or, at least, was in the process of stabilizing.

Encouraged by those not-so-bad signs in the final quarter of the year, traders, portfolio managers and other junk market participants queried by Prospect News for the most part opined that barring any unforeseen events, 2012 would be a year of decent, if not exactly overwhelming, returns, with many predicting that holders would at least earn their coupons, and possibly a bit more.

They said with the economy expected to continue stumbling along but the default rate likely to also stay low - helped by the surge of new issuance the past several years that eliminated much of the refinancing risk formerly present in the market - junk would remain a very attractive asset class relative to such rivals as Treasuries, investment-grade corporates and equities.

Painting by the numbers

The picture of two essentially different markets joined at the mid-year hip like a pair of Siamese twins is borne out by a Prospect News analysis of indexes used as a common measure of high-yield market performance.

For instance, the widely followed Merrill Lynch U.S. High Yield Master II Index - which closed out 2010 showing a return of 15.19% - broke out of the gate as 2011 began, and quickly moved up. It hit a peak return for the year 6.362% on July 26.

However, things went downhill from there, with the slide starting amid the late-July battle over raising the U.S. debt ceiling, followed by the unprecedented loss of America's vaunted AAA rating - with Standard & Poor's warning that action must be forthcoming to meaningfully cut Washington's huge debt load if further negative ratings moves were to be avoided.

The index bottomed in early October amid general financial market volatility linked to the meltdown in the sovereign debt of some of the weaker European economies such as Greece and Portugal, dropping to a 3.998% loss for the year on Oct. 4. It was a long, hard slog back up after that, although eventually, the ML Index climbed back above the psychologically potent 4% mark as the year was ending, hitting 4.286% on Dec. 29.

Other components tracked by the Merrill Lynch index exhibited similar up-down-then partway-back up trajectories over the course of the year. Its average price for an issue tracked by the index, which had closed out 2010 at 101.859, hit a peak of 104.563 on May 11, then cascaded down to 91.189 on Oct. 4 and ended at 97.311 on Dec. 29.

The average junk spread over comparable Treasuries as measured by the Master II ended 2010 at 560 basis points, tightened to 481 bps on April 11, ballooned out to 901 bps on Oct. 4, and had come back in to742 bps on Dec. 29.

The average junk yield to worst, after closing out 2010 at 7.498%, declined to 6.644% on May 16, jumped back up to 10.117% by Oct. 4 and finished the year at 8.382% on Dec. 29.

Other market measures told the same story. The Markit North American High Yield CDX index, after finishing 2010 at 102.91, hit a high of 104.87 on Feb. 8, reached a low for the year of 85.60 on Oct. 3, and read 92.99 on Dec. 30; however, it should be noted that the Markit indices typically "roll," or change to a new series tracking CDS contracts linked to different bonds, twice yearly, on or around March 26 and Sept. 26, so the Series 15 readings at the start of the year are not directly comparable to the Series 17 readings currently in effect, although they conform to the general pattern seen in other indices.

The KDP High Yield Daily Index compiled by KDP Investment Advisors, Inc. finished 2010 with an index reading of 74.40 and an average yield of 7.32%. It peaked at 76.35% on May 10, when the yield reached its low for the year of 6.36%, and bottomed at 68.34% on Oct. 4, when the yield hit its high-water mark for the year of 9.04%. At Dec. 29, the index was reading 72.30, with a 7.48% yield.

A tale of two markets

Kingman D. Penniman, the founder and president of Montpelier, Vt.-based KDP, declared that "we definitely had a tale of two halves here - when you look at the first half of the year, we were on the way to exceeding [2010 year-end] forecasts - but then, obviously as we began to realize how serious the systemic risk in Europe was, the dysfunction in Washington, and concerns about U.S. economic activity going forward, things dramatically reversed in the second half and re-priced the high-yield market - which makes it attractive for 2012."

Jim Wolfe, the head of U.S. leveraged finance for RBC Capital Markets LLC, a New York-based arm of Royal Bank of Canada, said that 2011 was "almost two different markets as you look at the year in total," with the first half characterized by brisk new issuance - up by as much as 35% from a year earlier - as well as solid secondary market performance, while the second part of the year was quite another story.

He said that after that strong start - which dovetailed with trends in merger and acquisition activity in the economy generally - the junk market "obviously slowed down beginning in June, then you saw the big drop-off and significant increase in volatility in July that lasted really through September. October saw a balance, and then we've continued to see volatility through the remaining part of the year."

It was, he concluded, "sort of a story of two markets, or two years."

Junk caught by surprise?

Market participants generally agreed that while both the European and American government debt problems certainly have been building up for years, with critics of such spending warning that things would come to a head sooner or later, perhaps not even Nostradamus himself could have forecast the sudden slam they would give the junk market in the latter part of the year.

Wolfe's colleague at RBC, Kete Cockrell, the company's head of U.S. high-yield investment banking, noted that "it's easy for someone to be a Monday-morning quarterback and turn around and say [the European debt/ U.S. deficit problem] was obvious and anyone should have been able to see it coming."

He pointed out that at the end of 2010, "we thought that there were a couple of different scenarios that could occur, one of them being the European crisis raising its head - but the other one was if things had continued to be good, we thought that other pressures would have come into the high-yield market."

One such pressure would be the impact of a renewed burst of inflation to go along with a rapidly reviving economy, while other possibilities that were being seriously considered at the time included a strong rebound in other asset classes, and whether that might act as a magnet to pull funds out of junk.

At Deutsche Bank's New York-based wealth-management unit, DWS Investments, Gary A. Russell, a managing director and high-yield portfolio manager, suggested that probably no one in the market "thought that we'd run into the extent of the problems we're seeing in Europe. There certainly was a risk - but I don't think that anyone had as their main scenario at the beginning of the year [what] developed that way as the year went on."

Russell said that in the first part of the year, "we started trading up significantly," and even the loan market got into the act, with a number of covenant-lite deals. "I thought that was going to be the beginning part of the re-leveraging, and maybe eventually seeing some LBOs - but I would say that with the declining risk appetite, due to the volatility they had in Europe and the default risk in Europe, that basically had a knock-down effect on all other markets, which stopped the whole re-leveraging phase in high yield."

While all of this was going on, "results for individual companies were quite good - clearly, the macro risk coming out of expectations of having a recession in Europe, a slowdown in China or Asia - in general, THAT's what pushed high yield off of its highs, given the extra downside risk that people had to price in," he said.

Mathew Van Alstyne, chief of research for Odeon Capital Group LLC, a New York-based boutique broker/dealer, investment banking and asset-management firm, said that "we came into the year thinking the market was priced essentially for perfection, if not pricing a little bit better than perfection - a recovery was assumed, a good recovery, a strong recovery, with job growth, housing stabilization and earnings growth. By and large, you had some of the earnings growth happen - but job growth hasn't been there, housing has actually continued to underperform, and then, obviously, there was the factor of Europe.

"I don't know if it was entirely foreseeable, but as a risk, it was foreseeable that that risk was out there. So it shouldn't have been a shock to anyone that things could have gone wrong there."

He meantime said that the downgrade in U.S. government ratings following the late-July debt-ceiling brouhaha was more of a psychological blow to the financial markets, including junk, a "wake-up call" on spending, but other than that, "I'm not sure there's that much effect. At the end of the day, the U.S. government is probably the source from which other ratings should be derived."

He continued that even after the downgrade to AA, "I don't think that anyone who was marking their bond and trying to benchmark it to AAA immediately changed their benchmark from Treasuries to some other AAA benchmark."

Where do we go from here?

With the financial world generally and Junkbondland in particular having by now gotten used to the new environment - continued uncertainty growing out of the ongoing debt and deficit situations in Europe and the United States that occasionally flare to crisis proportions, coupled with the current slow-growth economy - a veteran high-yield trader said that "if nothing happens with Europe, meaning if they continue to draw up plans that really don't mean anything, and the world just allows them to continue to do that, I would think that we're probably looking at a coupon-plus return."

He estimated that this would come in at "somewhere between 8% and 12% possible, on the conservative side, for total return. So it would be coupon-plus a couple of points of upside. If the economy stays like this and the Fed eases, or continues to hold a zero-rate policy, then the return could go higher - it could go to 15%."

His was about the highest estimate offered by the various market participants Prospect News spoke to. He explained that "the rationale is that every investor in the world is being forced to look for yield in some way, shape or form. Some are going after munis, some are going after high-dividend stocks, and others are willing to roll down the credit curve.

"The insurance companies and the pension funds are especially squeezed. And they have credit analysts that look at high-grade corporate paper and in many cases, they have high-yield analysts. So what they are doing is - where it is allowable - they are putting on more high-yield paper, and that will cause a spread compression over and above what might otherwise occur."

In contrast, another long-time trader took a decidedly more pessimistic view of 2012. He said that between January and the election in early November, "it's going to be more of what you've seen the last couple of months - it's not going in one direction or the other, it's just basically turning along. So maybe in those 11 months, the market's unchanged but you're just earning the average coupon, up 6% to 8%."

Then comes the election, which he said "will be either good news or bad news, depending on what party you're in. I think that no matter who wins, the market may sell off, so you may give up the gains you made that year, even if it was just the accrued being paid out. So long story short: 2012 is probably a flat year, or flat-to-down slightly, just because there's nothing good coming ahead. I don't see a rainbow at the end of the road."

Elaborating on that theme, he pointed to the recent decision by the Obama administration to put off until 2013 any consideration of the controversial Keystone XL pipeline project to bring Canadian-produced shale oil down to the U.S. "It was just a classic disappointment - 'oh, I'm not going to make a decision until after the election.' So everything just gets put on hold for the next 12 months and we're just in this state of misery."

The trader concluded "you go down to Main Street and nobody wants to hire because they don't know what's going to happen with taxes and the economy, this or that. On Wall Street, nobody wants to be a hero - because you don't know what's going to happen on Main Street."

More projections for 2012

Most of those we spoke to, however, stuck more to the middle of the road in making their 2012 projections.

Another trader opined that a 12% or 13% return "is not going to happen, the market's not going to fly." He estimated that the total return would come in around the 6% or 7% area.

A colleague was a bit more bullish, suggesting that "some of the fear has subsided, and U.S. companies' results seem to be half-way decent. Given that Treasuries [yields] are going to stay weak, I think we're going to do OK in 2012. We should do better than the coupon for the year."

"Back when our market was yielding 7%," he continued, "for the sake of argument, the 10-year [Treasury] was yielding 3.50%. Now with the 10-year below 2% and our market yielding over 8%, there's some room for improvement there. You're not going to get a 20% return - but you can get a 10% return, that's within reason."

KDP's Penniman believes that "right now, given what we know and making the assumption that there will not be a recession in the U.S. and the technicals continue to stay positive, the market can anticipate that you'll get your carry, at 7% to 9%, and depending on the extent of volatility and uncertainty, or as things clarify in Europe and here politically, in terms of how we manage our fiscal concerns, that you have potential for capital appreciation.

"But I think the base case is 7% to 9%, and if you don't get the spread compression in 2012, it's there for future years. So I think the outlook for high yield for the next several years is very positive - it's just a question of when you get that compression."

Odeon Capital's Van Alstyne thinks "you should be able to get 6% to 8% in this market. I think that's what makes the junk market more attractive than any other space - the volatility-adjusted return is probably a lot better in the junk market than in any other sector."

Similar projections came from Wolfe and Cockrell of RBC, both seeing returns in the mid-to-high single-digit range - Cockrell said that "what you're looking to do, probably, is pretty much earn your coupon; with the average coupon right now still over 8%, [that] would be a nice yield."

Russell of DWS was just a shade more cautious, projecting that "I think you're looking at coupon-minus. Right now, you're at 8½% [for average junk yield] - I think you're going to get a little less than your coupon."

Barclays Capital, in a year-end research report, predicted that 2012's total return should come in between 5% and 7%, "with the performance back-end loaded." The investment bank said that based on its own proprietary interest-rate forecasts, "changes in rates over the next year should approximately offset the Treasury coupon."

Among several other large investment banks, Wells Fargo Corp. also steers a middle course of 6% to 7% as a total return. JPMorgan is more bullish, with an 11% forecast, while Morgan Stanley seems to be the most bullish of all, projecting a "bull case" return as high as 17.9%, a much more likely base-case return of 13.6%, and a "bear-case" loss of as much as 8.2%, should currently low default rates suddenly spike upward.

Liquidity staying strong

One of the key drivers behind both high-yield new issuance - with successive record new issuance totals in 2009 and 2010, and the second-highest total ever in 2011 - as well as continued relatively strong secondary market performance, has been the ample supply of liquidity in the market.

As of the week ended Dec. 21, high-yield mutual funds - considered a key gauge of overall junk market liquidity trends - showed an estimated year-to-date net inflow of some $10.5 billion, according to a Prospect News analysis of the fund-flow statistics generated by Arcata, Calif.-based AMG Data Services.

That was just a little below the peak year-to-date level to that point of some $11.06 billion seen in the week ended Nov. 16, and well up from the estimated $520 million net outflow for the year recorded in the week ended Aug. 31, after several consecutive weeks of large outflows wiped out what had been a sizable inflow bulge up till that point.

Fund-flow statistics generated by another service, Cambridge, Mass.-based EPFR Global, whose methodology differs from that employed by AMG, moved more or less in a similar pattern, with year-to-date inflows at Dec. 21 estimated to be about $5.7 billion.

KDP's Penniman is of the opinion that the funds keep flowing into high yield because both the relative performance of other asset classes, as well as their outlook, are worse, versus junk.

Penniman noted that most of the money that has come into junk has come in just over the last several months - both AMG and EPFR have reported a number of billion-dollar-plus inflows during the fourth quarter, including all-time record inflows for each of $4.25 billion and $4.76 billion, respectively, in the week ended Oct. 26. These were partially offset, but only partially, by a couple of billion-dollar outflows as well.

Penniman said that "it's indicative of people looking at what the environment is for next year, and where they want to structure [their investments]."

Junk, he said, has "a current carry of 8% or 9%, and knowing that you have an excess spread relative to any kind of feeling for what the default outlook will be, you can see the potential for spread compression, you can absorb any kind of interest-rate shock, on a relative basis. I think high yield is going to do very well, and I think at the beginning of the year, certainly, and probably for the entire year, it's defensive because of the uncertainties."

With the economic outlook for the upcoming year "not looking too hot, depending on whether they get serious on reducing the budget and fiscal tightening," it will be a choice for investors, he said, "of nobody's going to be doing well - but where do put your money and where do you get a return that compensates you for the risk? And I think it's going to be in defensive high yield."

What's hot - and what's not?

For the coming year, Penniman said that KDP is "still very positive on energy, on telecoms - both integrated services and wireless - media, in terms of cable, and there are some electric generation that we continue to like.

"If you take away the steels, we like the metals and mining and the coal and some of those other companies. So that's where we would be looking to focus a lot of our attention on."

He also said that investors will be trying to find those companies that "given the cautious state of where we are and the uncertain environment, the companies are actually trying to become investment grade - and there can be a lot of pickup there when you cross from the BB into the BBB area."

One possible name in that area: Ford Motor Co., and its affiliated Ford Motor Credit Co. LLC. While the KDP boss believes that Ford is more likely to stay at BB+ for now, "just because we're a little bit uncertain in terms of what's happening in Europe and China and some other places" where the Number-Two U.S. automaker sells vehicles, he notes that there have been a lot of recent positives for Dearborn, Mich.-based Ford, including its recent conclusion of a comprehensive contract with its unions, buying four years of labor peace, and the announcement earlier this month that Ford will reinstate a dividend for shareholders, seen as another sign of the company's economic strength.

Among other interesting credits Penniman mentioned in a similar vein were International Lease Finance Corp., which just did a well-received split-rated bond deal that played to mostly junk investors, and Ally Financial Inc.

Another area worth looking into, he said, are "credits that have high coupons, non-call, that you may see companies - given the fact that there is liquidity, strong technicals and low interest rates - just look to tender for those bonds and take them out."

Among other sectors, he said that gaming "seems to still be doing pretty well, because of other areas around the world in addition [to the U.S.]."

He said his firm was "still relatively positive looking at health care - some are concerned about health care because of the uncertainty coming with the government regulations in Washington, but I think when we look at health facilities, we do like them."

However, "in terms of areas we perhaps are less [optimistic about], we don't necessarily like paper and forest products, and I think all transportation."

Security first

Odeon Capital's Van Alstyne counseled that "the places you want to be in are either non-cyclical businesses or secured credits. And then even from that, you have to do your homework - you have to sharpen your pencils and know what credit you're buying."

He cautioned that not all secured credits give the same level of protection, pointing to the recent bankruptcy filing by AMR Corp. and its principal operating unit, American Airlines, Inc., which caused many of the Fort Worth, Texas-based airline company's bonds to slide - even some of those secured by less-desirable assets such as older aircraft. "There are people even in that, who thought they had decent security - but it's not as decent as they thought it was."

As to sectors, he said that investors should "stay with non-cyclicals - utilities, pipelines, oil and gas, and to some degree, ships." The overriding theme, he said, should be "commodity-based, asset-based - I mean hard assets, real assets at the end."

In contrast, he would avoid "more ethereal-type, inventory-type credits, where you're taking some undisclosed amount of inventory as your collateral. I would think that's the type of area I would avoid, so I would probably avoid middle-market retail, or any other cyclical-type business.

Like many of those surveyed, Van Alstyne was down on any sectors dependent on consumer spending, noting that "we've seen a number of quarters - I think it's over three years now - of declining consumer debt, when it's offset by consumer savings. You'd have to see a reversal from that [for the consumer area to do well], which I would suspect would come from confidence in the jobs market, confidence in the housing market." With those conditions needed for a consumer revival, he flatly proclaimed that "nothing on the horizon is out there that makes you believe that something is pending."

At DWS Investments, Russell said that "in general, we're constructive on single-Bs, BBs, and selective on CCCs."

He recommended that investors should "overweight within the single-Bs, probably with a bias toward adding to BBs on any kind of volatility - you'll get some opportunities to buy some good credits at good prices."

He said that DWS generally likes the cable space, both domestic and international. In the latter area, Germany looks particularly promising, because "they're just rolling out all of these other services, for digital, and telephone and internet, so penetration isn't as high there [as in the U.S.], bills for individuals aren't that high, so you do have similar credit stats right now - but with more upside on credit improvement, given that we expect the results to improve for those companies."

He also noted that Germany and the Netherlands, another promising European cable area, are the kind of "core countries in Europe which aren't having the issues you're seeing in Spain, Greece or Italy. So there are some credits in there that we like in that sector."

Several of those whom we spoke to mentioned that domestic cable companies and other media outlets should do pretty well this year and thus are ripe for bond investors, given that 2012 has a presidential election as well as the usual House and Senate contests that come up every two years, and the Summer Olympics - another event which only happens once every four years - will be on, providing broadcasters and other media companies numerous opportunities to clean up on advertising revenue.

Russell thinks that a lot of that is already priced in, although he allows that "it's certainly less volatile on the downside, so it's constructive." He said that the expectations that these companies will do well are already there, "but if you get some volatility, it certainly is nice to maybe add to those types of names, given that you would expect to see OK numbers."

While those areas will be hot, he believes the consumer segment will not.

"In general, in the homebuilding and building materials, we're cautious, given that we don't see a rebound on the building side." He said the same holds true for retail. While high-end retail "has continued to do well, we're a little cautious in names in that sector, given the macro risk and where yields are printing right now."

But RBC's Cockrell said that the retailing industry names that have lately got the best reception in the marketplace have been "the ones that benefit from a more discerning spender" - the type of bargain-seeking customer who might shop at one of the 99 Cents Only Inc. stores in the Western part of the U.S. The City of Commerce, Calif.-based "extreme value" retailer brought a $250 million issue of eight-year bonds to market on Dec. 14, the last actual junk bond of the year, with RBC as the left-side bookrunner. Cockrell said the company "is clearly a beneficiary of a more frugal shopper, and we found that to be very receptive to investors despite its CCC rating on the bonds. We think that's indicative of how investors probably feel about certain retailers."

A lesson learned?

A junk trader opined that despite the shocks generated by the U.S. and European debt problems, "I thought that the high-yield market performed pretty well, overall. I think we got back to a lot of basics. Companies' balance sheets got a lot stronger this year, and while there was a lot of emotion in the buyers, the mutual funds that we talked to - for the first time - really took a hard look at not only the balance sheet - but could the companies refinance their debt? So we got back to the fundamentals to a large extent this year."

He suggested that "this is going to continue to a large extent into 2012. I personally think the balance sheets are pretty strong and replenished," with companies having paid down a lot of short-term debt and pushed maturities out, while taking advantage of market conditions to lower their overall cost of credit, "and I think high yield represents very good opportunity - as long as we don't get crazy and go back into that speculation bubble again."

He said that what investors sometimes forget is "that high-yield bonds are no more than equity with a coupon, and you're senior in the capital structure. As a result of that, the returns on the bonds are still pretty attractive, relatively speaking. So I'm just constructive - as long as the speculation fever doesn't return."

He said that "unfortunately, a lot of the hedge funds have short memories - but the recent past, where people have gotten clocked, I think, is gonna be embedded in them for quite a while - and they're gonna stick to the fundamentals."

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