Outlook 2010: High-yield bond market to party like it's 1991 - for now, anyway

By Paul Deckelman

New York, Dec. 31 - First the good news: the party is still going on, and man, it's really been a wild one.

Now for the bad news: all good things must come to an end, and Junkbondland's surprise, year-long Bacchanalia is no exception.

Even now, most of the good times have already been had, the really cool and good-looking people have left, the wet bar is down to its last few bottles as the bartender looks at his watch, while the guys in the band are starting to gather up their gear as they swing into their final set of the night, because this gig is almost finished.

Loose translation: the junk market is rolling into 2010 with a nice head of steam built up during a 2009 advance variously described by market participants with adjectives such as "spectacular" and "stellar. The mere changing of a calendar page from one year to the next is not going to immediately stop that momentum - but sooner or later, it will inevitably run out and the party will indeed be over.

Most everyone acknowledges that high yield has come so far, and so fast, in bouncing back from the 2008 debacle, posting record returns that are simply unsustainable going forward. Several of the traders, analysts and investment managers interviewed for this article used some variation of the phrase about "the low-hanging fruit" having already fallen or been plucked from the trees - meaning the easy money has been made.

While they generally expect the junk bond market to continue to post positive returns and see spreads continuing to tighten, at least in the first part of the new year, the participants mostly expect returns in the mid single-digits range - quite a letdown from the unbelievably gaudy 50%-plus gains notched this past year. A number of sources said junk investors will at least - or maybe at most - make their coupon yields, with perhaps a little extra upside.

Though winding down, the Junk Bond Jubilee, which has been fueled by an unprecedented surge of liquidity, will continue for at least a while longer, they say - for as long as money keeps coming into the junk universe because it is a more attractive investment vehicle than other asset classes.

The pace of activity could come to an end if, say, stocks - which had their own 2009 carnival as they rebounded solidly from the pounding they took in 2008 - suddenly heat up and lure away fickle investors looking for The Next Good Time. But even if that happens, high yield won't be left completely high and dry, as an improved equity market could also work to the benefit of junk by helping issuers looking to refinance.

A year like no other

The breathtaking strength of the 2009 junk juggernaut can be measured by a look at some of the widely followed statistical measures of market performance.

For instance, the Merrill Lynch U.S. High Yield Master II Index had opened the year on Jan. 2, 2009 with an index value of 436.991, a yield to worst of 19.431% and a spread-to-worst of 1,757.744 basis points. The average price of a security tracked by the index was $61.415.

Fast forward to Dec. 24, the abbreviated final trading session before the Christmas holiday break, when the index had accumulated a year-to-date return of 56.861%, its peak level for 2009. It had an index value of 682.152, a yield to worst of 9.099% and a spread to worst of 666.789 bps - the latter figure nearly 1,085 bps tighter than where it was when the year opened. The average price of a security tracked by the index now hovered at $94.95.

Barclays Capital, in a year-end research report issued in early December, noted that its own proprietary high-yield index had returned 53.18% as of Nov. 30, after having lost nearly 30% the previous year.

That return contrasted with the historical average of 7.40% that junk had racked up over the previous 15 years and was also nearly 7% over its previous all-time peak, reached in 1991, when the junk market was bouncing back from a variety of negative events, including an economic recession, the fallout from the collapse of high-yield powerhouse Drexel Burnham Lambert and the savings-and-loan crisis.

Barclays further said that as of the end of November, the average price of a security tracked by the index was $92.82, versus the 15-year average of $90.42. Its yield was 9.77%, versus the average of 10.37%, while its OAS spread was 742 bps - although that was wider than the historical average of 528 bps.

The Markit CDX NA High Yield Index as of Dec. 24 stood at 99.95. It had finished 2008 at 79.9 - and continued to decline in early 2009, reaching a nadir or 66.65 on March 9, before coming off that bottom to eventually return to about the par level as the year was ending.

"We have come back a long way," said a trader who tracks the index's movements on a daily basis.

The KDP High Yield Daily Index as of Dec. 24 closed out the session at 71.05, with a yield of 8.11%, versus its reading of 52.77 and yield of 14.58% on Dec. 31, 2008.

2009 - 1991 redux?

Kingman D. Penniman, the founder and president of KDP Investment Advisors Inc., an independent bond market research and advisory service based in Montpelier, Vt., said that 2009 was an example of the old market saw that "what goes down, must go up.

"The pendulum swung one way in 2008. It came roaring back in 2009. We saw indiscriminate selling in 2008, which led to indiscriminate buying in 2009."

Noting the fact that forecasters - and he included himself among them - had largely been caught by surprise by the junk market's behavior over the past several years - less-than-expected returns in 2005 and 2007, unexpected strength in 2006 and, especially 2009, and the completely unforeseen 2008 market collapse - Penniman quipped that "maybe we have a better chance in 2010 to be more on the mark," suggesting that forecasters perhaps should "say that what we don't want to happen is going to happen, so that good things happen."

Penniman said that there were some similarities between the 2009 market recovery and the very strong rebound which had been seen in 1991 - although there were also significant differences.

"We're clearly way ahead of [1991], when you look at where our returns for the year are right now, and the market is continuing to go strongly."

He noted that his company's proprietary KDP High Yield Index was up by 44.4% on the year in 1991, while it was up by 45.7% on Dec. 22, "so we're pretty much tracking 1991.You had outsized returns when you look at the index numbers."

In both years, Penniman continued, "you had significant new people, non-traditional people, coming into the market, where debt became the new equity, which is certainly the case in 2009, as was the case in '91." Also in each year, the upturn followed strong federal action to calm and reliquify the financial markets - the Resolution Trust Corp.'s seizure and liquidation of failed thrifts in 1991, and the Federal Reserve's slashing interest rates to nearly zero, coupled with government stimulus programs like TARP and TLGP this time around.

However, he pointed out that there were notable differences in the size of the market - today's junk universe has grown to around the $1 trillion mark, far surpassing its earlier counterpart. Market cycles are now shorter, and volatility is more concentrated and intense than in the past.

"I think 2009 was somewhat a little stronger in its dynamic - but'91 is certainly indicative, and comparable," he said.

'Equity-like returns'

Penniman further observed that "when you have this kind of outsized return, people say that means the market is going to roll over" and die in the following years. However, the KDP chieftain said, "when you look at 1992 and 1993, the returns were 17.9% and 19.4% - so some of your strongest returns in the high-yield market follow your extreme, outsized returns. So going into 2010, we're still looking for equity-like returns."

By that, he means "at the most, we're going to earn the coupon, and we're going to see some outperformance by selected credits in the CCCs, and a little bit of spread compression in the higher quality [names]. We're looking for no more than 6% to 8%" on the low side, to a high of around 10% to 11%, "and with a big focus on higher-quality credits, because that's where you want to be."

High yield, declared Bob Bishop, the chief investment officer at SCM Advisors LLC, a San Francisco-based investment firm with more than $3 billion under management, "still has some things going for it."

That includes the Fed continuing to keep interest rates low and the economy liquid at least through March, when the central bank's program of buying mortgage-backed securities from Fannie Mae and Freddie Mac is scheduled to expire, as well as continued modest economic growth - neither the dreaded "double-dip" recession which some economists have warned about, nor a "V"-shaped steep climb by the economy off its bottom, mirroring its sharp slide.

Modest growth, said Bishop, "is not so good for stocks, but not so bad for high-yield bonds."

There is the potential for a couple of percentage points of economic growth in a low-interest-rate environment, because the Fed has said it is going to keep interest rates low and plans to pursue quantitative easing through March.

"If you add those things up, it's a pretty sweet spot for high yield," he said.

Bishop noted that with the average dollar price of a high-yield credit, as measured by the Barclays index, standing around $93 as of the end of November and the average yield around 10%, "which is still a very hefty spread, and starting where we are in the marketplace, where at some point, you're going to run into par compression, there's still 15% total return for high yield in 2010. So it won't be like last year [2009], but we think there's still a decent tailwind that should make high yield a pretty good performer."

He said that the 15% scenario should hold even if the Fed, as is widely expected, stops buying mortgage-backed paper and adding liquidity to the economy, as long as "they'll be relatively modest in their approach to doing that. The economic numbers won't be that strong, and that means that we don't anticipate them wanting to be too aggressive."

Political influence

Another possible factor in the equation, he acknowledges, is politics, with the Obama administration likely to lobby Fed boss Ben Bernanke to not move too aggressively, if at all, to begin tightening liquidity in the face of a still-only modest recovery and important mid-term congressional elections coming up.

While the Fed chief in theory is supposed to ignore the political fray, "it will be awfully hard, considering everything that's happened and the fact that it's an election year," Bishop predicted. "It's going to be pretty hard for him to ignore all of those things."

With expectations of only moderate moves, if any by the Fed, to withdraw liquidity underpinning the 15% total return prediction - although Bishop allows that the Fed could act more aggressively to exit from its current policy of quantitative ease, which "could change things a little bit" - he said that SCM is looking to increase its high-yield exposure in its core-plus accounts, which combine junk bonds with other types of securities and to make sure that it is fully invested in its dedicated high-yield accounts.

A trader at a sellside shop opined that "the average [junk bond] coupon is about 8%, so you'll probably get that, maybe some pick-up, at least through the middle of the year." Several other traders at other desks agreed that returns would come in around 7% to 8% for 2010.

The first trader included the caveat "that the thing that's driving this is Treasury rates. As long as Treasury rates are as low as they are and investors try to decide where to put their money - the stock market gets a little scary - bonds seem like a decent place and if the alternative is equities or Treasuries, it sounds like corporate bonds and high-yield bonds are the place to go."

However, he added that "if later in the year Treasury rates start to rise, it will take some of the steam out of our market."

Floating on a sea of cash

A trader who pronounced 2009 as "one very stellar year, which you probably won't see [the likes of again] for a very long, long time," projected that how long that momentum continues into 2010 "is going to be function of the fund flows coming in, and it looks like as long as we keep having positive fund flows coming in here, you're going to keep having this appreciation."

Indeed, one of the major stories behind the junk market's remarkable year in 2009 was the very remarkable flow of funds into the market.

The most obvious evidence of that was the weekly statistics from AMG Data Services measuring the monies flowing into or out of weekly reporting high-yield mutual funds, considered a key barometer of overall junk market liquidity trends.

As of the week ended Tuesday, Dec. 22 - the next to last week of the year - cumulative inflows measured some $20.213 billion, a new record, narrowly shading the previous mark of $20.14 billion, set in 2003. Inflows had been seen in fully 46 out of the 51 weeks of the year to date, according to data compiled by Prospect News.

Counting some $12 billion of cumulative inflows into monthly reporting funds, the total of weekly plus monthly reporters stood at $32 billion, which a market source said was substantially higher than the old record of $27.2 billion, also set in 2003 - a year not unlike 2009 in some ways, as the high-yield market bounced back strongly from an unexpectedly bad previous year, causing junk to jump an astounding 30% on the year in total return and fueling a then-record $138 billion new-deal borrowing binge.

In 2009, as had been the case in 2003, what drew retail investors to put money into the junk mutual funds - while also attracting the even larger investments from institutions like pension funds, hedge funds and insurance companies, which can't be as easily quantified, tracked and analyzed as the mutual fund flows - was junk's great attractiveness versus other investment vehicles.

Besides completely routing U.S. Treasuries, the 53.2% junk total return reported by Barclays Capital by the end of November, for instance, was more than triple the near-record 17.2% return racked up in that same time frame by U.S. investment-grade corporate bonds and was ahead - though not by all that much - of the 49.2% return generated by U.S. leveraged loan paper.

Gary Sullivan, a managing director in charge of high-yield bond portfolio management and high-yield strategies for DWS Investments, the U.S. retail asset management business of Deutsche Bank AG, said that "the asset class is why you're getting these inflows. The flows are coming out of the money markets, looking for yield."

He said that we haven't seen a lot of those flows go into the equity markets. High yield is an attractive place for them."

A trader said that "it's getting to the point now where I can open up any newspaper or magazine, and all you hear about, if you look up something about investing, is that the junk market has returned 55+% this year. That's all you're hearing about, and that's getting the Joe Retail Investors to put more money in their mutual funds or their 401Ks, or whatever they're using." However, he cautioned, "at some point, the high-yield market is not going to be THE hot market to start throwing cash at.

"The big $64,000 question is: is money going to keep pouring into the junk market? If you have large amounts of funds exiting this sector, that could affect those [6% to 10% projected] gains going forward. That's one of the things nobody really knows the answers to: how long is this money going to keep pouring in? And when does the reversal start, and money starts coming out? Is it six months, or two years from now? Or is it a month from now?"

Answering his own rhetorical question, he opined that the reversal of inflows "probably isn't a month from now, but it could be somewhere from six to 24 months down the road, you could see the pendulum swing the other way, and [flows] start having an exit."

Junk bonds versus equities

While junk bonds are fixed-income instruments most often compared to Treasuries or investment-grade corporates, sometimes, it seems that their main rivals, at least for the affection and interest of opportunistic investors, are really over on the other side of the investment world's fence - equities.

Both attract the more adventuresome investors not satisfied with the absolute safety, but low yields of Treasuries or the relative security of clipping high-grade coupons; indeed, one junk trader described high yield as "equity with a coupon." Both tend to do very badly in times of economic turmoil - in 2008, when junk bonds suffered a shocking 25% loss on the year, stocks were also getting slaughtered, with the bellwether Dow Jones Industrial Average down as much as 42.16%, ending off 33.8% on the year - and both tend to bounce back strongly when things pick up a little.

However, in 2009, at least, it seems that junk had the bigger rebound and was the clear winner; while high yield bonds had gained more than 56% by Christmas Eve, according to the Merrill Lynch junk index, the Dow had a year-to-date gain of 19.9%, while the 65-stock Dow Jones composite index, including the components of its Transportation and Utility indices along with the Dow, had gained 17.1%.

Among broader market measures, the Nasdaq composite index had gained 44.9% - close, but not close enough - while the Amex composite was up by 30.5%, the NYSE composite was up 24.7% year to date, and the Standard & Poor's 500 index had a 24.7% return. The various Russell indices (1,000, 2,000 and 3,000) had all generated returns around 27%.

With junk so far ahead, many investors who might ordinarily be watching The Big Board were instead putting their money into bonds - making up some of those new, "non-traditional" high-yield investors whom KDP's King Penniman had earlier referred to. But such hot money is notoriously fickle, and junk traders and analysts acknowledge that should equities suddenly start to heat up, high-yield inflows could slide.

But while they are often rivals for the same investment dollars, it is by no means true that what's good for equities has to necessarily be bad for junk bonds.

Penniman pointed out that one of the things which makes junk such an attractive investment is that while it can do well in times of only meager economic growth, as is expected this upcoming year, "if the economy unexpectedly benefits, you're still going to benefit from higher earnings and the improvement in equities, because if the equity market gets stronger, one means of refinancing - and some people have pointed to it for 2010 - is that in a strong equity environment, a lot of these over-leveraged [junk] companies are going to try and issue equity to de-lever and improve their credit profiles."

Investment ideas for a new decade

Penniman said that "when we look at where the market is, we still want to be in industries and companies that have free cash flow - you want to be in consumer staples; you want to be in power; I would say technology continues to be a strong area; and certainly telecommunications continues to be a strong area."

He said that there are "certain machinery companies where we do see the markets in some of the BRIC [Brazil, Russia, India and China] or developing nations are going strong and given where the dollar is, I would say that those industries and companies that are exporters will probably have better earnings than those that are mostly dependent on the U.S. It's a way to play the emerging markets and stay in the U.S."

SCM's Bob Bishop is also looking abroad; that desire for some global diversification led SCM to get involved in Wind Telecomunicazioni SpA, a European cellular company.

"We think the U.S. recovery is going to be kind of moderate, facing headwinds from higher taxes and regulations and still a kind of weak financial system. So one of the things we're going to do is stay with industries we like; we've always liked telecom, for example. I think we are going to be doing a little international diversifications, to make sure we are not just dependent on one economy, should we be wrong and things start to head south," Bishop said.

He said that rather than dabble in the emerging markets space, his company will look for high-yield opportunities in developed markets like Italy.

Beyond that, he said that SCM "is less defensively postured now" than it was, say, a year ago. He believes that the big rally in bonds rated CCC and below - CCCs were recently showing a robust gain of more than 80%, while CC and below had nearly doubled - has gone about as far as it can go; so, on the spectrum of defensive on one side to highly cyclical and very leveraged on the other, "we'd be smack dab right in the middle - a good, solid single-B credit that generates free cash flows, has got a good market position and good management, is the kind of thing we're going to focus on, while [in 2009], we were more defensively positioned, more BBs and probably less likely to take on levered companies."

Barclays Capital, on the other hand, is urging investors to lift a barbell - not to hit the gym, but to go into issues at the opposite ends of the high-yield credit-quality spectrum, BB paper on the one hand and CCCs on the other.

In its research report, Barclays said that despite their interest-rate sensitivity, "we like double-B credits because they are trading exceedingly wide of long-term averages." Meanwhile, although the CCCs, having enjoyed the spread-tightening that goes along with the strong rally they've had, are trading "considerably tighter to historicals than their higher-quality counterparts, the low-quality segment of the market generally has the lowest Treasury sensitivity and therefore, should shield portfolios from rising rates, while benefitting from improving fundamentals."

The return of M&A

DWS Investments' Gary Sullivan, who sees the junk market producing "coupon returns" in the 7% to 10% area, with continued spread compression to around high yield's historical average levels around 500 bps from current levels around 700 bps, is constructive on acute health care, long a favored DWS sector.

The view comes amid possible changes to the health care system bringing more people under some form of insurance. He also cites other potentially positive events such as initial public offerings for companies not currently publicly traded, such as HCA Inc.

Sullivan anticipates a modest return of merger and acquisition and possibly leveraged buyout activity as a factor making junk names attractive, although such transactions would be more restrained than the kind of wildly leveraged deals seen in the past.

He sees the oil and gas sector as especially fertile ground for M&A activity, in view of the recently announced deal for ExxonMobile Corp. to acquire XTO Corp. - now investment grade but formerly a junk bonder - in a $41 billion purchase that includes assumption of some $10 billion of XTO's bonds and other outstanding debt.

A market source at an energy-oriented buyside shop also cited the XTO deal in asserting that "high-yield energy in 2010 may perform well based on, first, continued consolidation in the energy space, and second, a constructive outlook on energy prices, which could be underpinned by geopolitical considerations and a lack of immediate alternatives."

A trader delivered the truism that "you're always going to need energy" - which makes for some attractive names in that sphere, such as, for instance, Richmond, Va.-based coal operator Massey Energy Co. He too "definitely" sees a strong likelihood of M&A activity in energy in the aftermath of the XTO deal.

Away from the energy patch, he likes such areas as lower-priced restaurants such as O'Charley's Inc. or Wendy's/Arby's Group Inc., "because sometimes, people like to forget their misery or whatever the case may be, and they'll go to the lower-priced restaurants and go out and have a meal. Those bonds, such as Nashville-based O'Charley's 9% senior subordinated notes due 2013, now trading around par, or Atlanta-based Wendy's/Arby's 10% notes due 2016, recently around 108, "have come back and will be OK."

The source said of West Chester, Ohio-based AK Steel Corp.'s 7¾% notes due 2012 that "you're not going to make a lot of money, but they're still trading at a little bit of a premium, that kind of thing." However, he said bonds of some of the other cyclical manufacturers had outpaced actual improvements in the companies' finances and were likely candidates for a sale.

Duration, quality and size

At another desk, a trader, rather than pick out sectors, is generically focusing on duration and quality. He likes very short-duration paper, and BB-rated credits, since the big profits from riskier credits like those at CCC or below have already been made and now, "there's an awful lot of good news already baked into that market."

Yet another trader believes that size matters. "I would want to stay in larger, more liquid issues, because as you have the pendulum switching, and folks one day decide everyone's a seller, you want to be in those larger, more liquid issues, versus those smaller ones that 'trade by appointment' because it may be harder to get an appointment for that trade."

He said that he has frequently seen what the noted junk bond guru Martin Fridson waggishly calls "the Roach Motel" effect: like the creepy crawlers lured into the popular bug-killing trap, investors can get into a bond - but they can't get out.

"You have these portfolio managers [who say] oh, I'm buying these smaller issues because they've got such a huge coupon to get them priced, and you try to explain to them 'hey, when the s--t hits the fan, you're not going to be able to sell that thing,' and sure enough, you see it happen when the next downturn happens - those are the names that trade by appointment when the market's hot, and when the market's cold, they don't trade at all. You just can't get out of them," he said.

Besides the large and liquid issues, the trader counsels staying in the shorter maturities, and higher up in the capital structure. "The time for going lower, longer and reaching for yield has probably passed, and it has paid off very well. Now is the time to probably re-balance your portfolio - since the market is not going to be rewarding you with 50%-plus returns."

The invisible man: the American consumer

Penniman of KDP is being cautious when it comes to bonds of companies in industries dependent on consumer discretionary spending, such as retail, leisure, gaming and lodging, "because the consumers have got several years of deleveraging before they ever get back - that's the one thing that when people are concerned about the economy, a significant increase in the savings rate could certainly put the kibosh on what constitutes 70% of the GDP.

"We think that unemployment is going to go higher than 10% and stay high for a while. We just don't' see that sector of the economy being a strong impetus."

That's also the view of Bob Lupo, a senior analyst at Buckman, Buckman & Reid, Inc. in Shrewsbury, N.J., who keeps an eye on the retailing and consumer sectors - and isn't too thrilled at what he sees.

While there have been some recent signs of economic stabilization, he said, "the [financial] markets have just taken off, beyond appropriately pricing that in and have gone way overboard in my view, particularly in the consumer sector - because the consumer is not back and I don't think is coming back. Their behavior has changed markedly, and we're going to be witnessing that behavior for a while.

"I would think that a lot of these high-yield retail names [would] kind of correct a little bit. I could be wrong, but I'm not very constructive on the economy. I think that the retailing names are too richly priced, in terms of their fundamentals, because I don't think the consumers are going to be back. So my question is, why are these retailers jumping up in price?"

For instance, Neiman Marcus Group's 10 3/8% notes due 2015 were being quoted at levels above 98, while Toys 'R' Us Inc.'s 7 7/8% notes due 2013 have risen above 101. Lupo said that high-end department store operators like Neiman Marcus and sector peer Saks Inc. and even the investment-grade rival Nordstrom Inc. "are going downscale. They are now going to lower prices, in terms of products that have lower price tags on them, because the consumer is holding back."

Another retailing industry subgroup that could see problems in the coming year and whose bonds are trading too rich is the supermarkets, which have "seen deflation in milk, and in dairy and other key product sectors, and that's continued.

"So if you have deflation in retail, what's that going to do to your top line? It certainly impacts it negatively. What this is going to do is intensify the competition, especially in the grocery sector, but also I think across retailing."

Lupo noted that investment-grade supermarkets giant Kroger Co.'s recent quarterly report noted a rising number of its customers using food stamps - a further sign, the analyst said, that the consumer sector is definitely hurting.

He said that with the official unemployment rate over 10% - and the real jobless percentage, counting those who've given up on finding work or who can only get part-time jobs and who thus do not show up in the official statistics, more like around 17% - consumers worried about their employment prospects are cutting back on their spending.

In such an environment, "the deep-discount retailing guys," such as Dollar General Corp., whose 10 5/8% notes due 2015 trade above 111, "did the best and it makes all the sense in the world why they would do the best - people are downsizing their needs and down-pricing their needs. I see that continuing, and so I see at some point, the chasm between that consumption reality and the prices of these retailing and consumer sector securities kind of hitting the wall and correcting and adjusting for what the new reality is," Lupo said.

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