Outlook 2009: New year brings hope investment-grade secondary will revert to traditional levels

By Paul Deckelman

New York, Dec. 31 - A funny thing happened to the investment-grade secondary market throughout much of 2008 - it turned into a pretty good imitation of the junk bond market, or, at least, what the junk market had been before junk itself was mostly swallowed up whole by the distressed-debt market, formerly only a small part of high yield, and the kind of "investment-grad-lite" 200 bps to 300 bps spreads which some junk issues had been sporting during the heady times in late 2006 and early 2007 had become just a pleasant memory.

As U.S. financial markets in general got smacked around by the continuing credit crunch that evolved from the subprime mortgage meltdown, traditionally tight investment-grade yields ballooned up, up and away, taking spreads over comparable Treasuries with them - especially since the latter spent the year inexorably tightening as fixed-income investors sought the safety of government paper. Credits whose spreads had been in the double digits saw those levels sometimes double and triple, and those already in three figures moved further up, to 500, 600, 700 bps over and sometimes more - the kinds of levels previously seen only in, well, junk bonds.

Some long-time high-grade financial names like Lehman Brothers Inc. and Washington Mutual Inc. actually migrated over to Junkbondland in 2008 - especially as the underlying companies themselves disappeared into Chapter 11, probably never to return, or at least, return looking anything like they used to. Other bonds, like those of Bear Stearns & Co., Merrill Lynch & Co., and Wachovia Corp. are still quoted around the high-grade precincts, but those companies, too, have ceased to exist, at least as the proud and distinctive independent entities they once were.

As the year began to close out, meantime, spreads were seen having come back in from their recent worst levels, helped by better market psychology in the wake of government efforts to straighten out the financial sector through the Treasury's TARP program, a revived new-issue market and investors' need to put sidelined cash to work. Barring anything unforeseen, market participants told Prospect News they expect that spread tightening trend to continue - as high-grade tries to get back to something resembling its old self.

A 'miserable' year

As it closed out the year, the widely followed Markit CDX NA I-G On The Run Index of high-grade market performance was quoted on Dec. 26 at a spread of 206.8 bps - versus the 80.97 bps level the index held when the year began on Jan. 2, 2008, its tight point for the year. In between, the CDX spread had leaped out to a level as wide as 279.67 bps on Nov. 21.

Spreads in general widened in line with a marked shrinking of comparable Treasury yields - the benchmark 10-year government note, which was yielding 4.024% on the last day of 2007, was yielding just 2.1% a year later, a nearly 200 bps pickup.

Looking at some representative issues, a market source noted that among the financial names, Goldman Sachs Group Inc.'s 5.625% notes due 2017, which had started the year trading at 199 bps over, were finishing it at 620 bps over, and its 6.25% 2017 notes had jumped out from 160 bps over to 510 bps over. The 5.55% notes due 2017 of Bear Stearns - now a part of the J.P. Morgan Chase & Co. empire - began the year at 310 bps over, a relatively wide spread for that time, reflecting the queasiness the market felt about Bear in the weeks before its early-March demise; those bonds were ending 2008 trading at 587 bps over.

Among the non-financials, Anheuser Busch Co.'s 6.45% bonds due 2037, which had begun the year quoted at 132 bps over, were pegged at 455 bps over at year-end, despite the big St. Louis-based brewer's having been swallowed up during the year by the even larger and presumably more financially stable international beer giant InBev.

Even among the AAAs, Johnson & Johnson's 5.95% bonds due 2037 had moved out from 90 bps over at the start of the year to 205 bps over at the end - one of the very few issues whose spread actually widened less than the change in the comparable Treasuries - while General Electric Capital Corp.'s 6.15% bonds due 2037 had widened from 124 bps to 345 bps over.

"I thought it was miserable," a secondary trader said of the year just passed. "The first three quarters of the year were miserable. There was no liquidity, everyone wanted to sell and there was really no bid in the marketplace and therefore, spreads widened out considerably, anywhere from 100 bps to 200 bps, and even more in certain situations."

Washington comes through

However, the trader said, "then, you got basically a complete reversal, in late November and early December, where no one could buy enough of the spread product."

He attributed the gains largely to the whirlwind of activity out of Washington, aimed at thawing the frozen credit markets. There were several interest rate cuts by the Federal Reserve, culminating in its Dec. 16 announcement of a 75 bps cut in its key federal funds rate target down to an historic low range of zero to 0.25% - larger than many in the market were looking for - and its promise to do everything it could to revive and stabilize the economy and the credit markets. The Fed also set up a facility to buy commercial paper, in order to unstick that stuck market.

There was also the Treasury-administered $700 billion Troubled Asset Relief Program, which doled out dollars by the billions first to banks, then to non-bank financials, like commercial lender CIT Group Inc., and eventually, even to GMAC LLC, the auto-loan arm of troubled General Motors Corp.

John Lonski, the senior economist for Moody's Investors' Service's economics analytical unit, said that "the Fed's aggressive moves to restore normal functioning to financial markets and to end the current recession" had had a noticeable impact on the behavior of high-grade bonds.

Lonski noted that since the Fed's move, yields had declined from a November average of 9.44% for Baa rated bonds of industrial companies to 8.40%, while the average yields for single-A industrials had tightened from 7.76% in November to 6.51%. He said that double-A rated industrial issues had likewise come in, to an average post-Fed yield of 5.37%.

With investors invigorated by action from the Fed and other arms of the government, December's returns for investment-grade corporate bonds were delightful. Heading into the tail end of the month, he pointed out that the average month-to-date total return as of Dec. 22 hit 5.95%, topping the 3.9% return that recently surging U.S. Treasuries had produced in that same time period. Meanwhile, the 13.3% month-to-date total return on just long-term investment grade corporates beat the 11.1% total return for that same period for long-term Treasuries.

The trader meantime said that "when the Fed came in, gave all that money to bail out [banks], and that TARP money, that money had to go somewhere, and there was still a lot of money on the sidelines besides the TARP money. You had money managers that had to invest the money, because it couldn't just sit idle, so it had to go somewhere. They were looking to where they could get a decent spread in a name that's going to be quite defensive, getting out of the bank and finance names," which were still thought of as troubled.

Accordingly, he said that "everybody kind of gravitated towards the higher-quality non-finance names - because they had so much exposure in the financials. So it was a scramblefest for whatever they could get their hands on in the high grade industrials and utility sector. An indication of that was [issuers] would bring new deals and they would tighten anywhere from 20 bps to 40 bps, sometimes 70 bps to 100 bps."

New deals shoot skyward

He recalled one particular deal - National Rural Utilities Cooperative Finance Corp.'s $1 billion offering of 10.375% notes due 2018, which priced on Oct. 23 at a spread of 608.1 bps over comparable Treasuries - and which "tightened over 100 bps, once the deal was priced."

Other big deals which came to market near the end of the year and which began to firm smartly right out of the box - leading some traders to say that the deals had been priced way too cheaply to begin with, in the interest of just getting them done in a nervous market - included Hewlett Packard Co.'s 6.125% notes due 2014, $2 billion of which came to market at 460 bps over on Dec.2 and then proceeded to tighten up nicely, FPL Group Capital Inc.'s $450 million of 7.875% notes due 2015, which priced at 596 bps over on Dec. 9, and General Dynamics Corp.'s $1 billion issue of 5.25% notes due 2014, which priced at 365 bps over on Dec. 8.

While all of this was going on, the financial side was also bringing its own new deals to market, helped by a Federal Deposit Insurance Corp. facility letting financials bring issues of three years maturity or less to market with a government guarantee, drastically cutting their funding costs.

That allowed such names as Bank of America Corp., J.P. Morgan, Goldman Sachs and American Express Corp., as well as regional lenders like PNC Funding Corp., Regions Bank and Key Corp. to strengthen their depleted liquidities by billions of dollars. The program was eventually expanded to allow such non-bank quasi-financial entities as the finance unit of John Deere and Caterpillar Inc. and GE Capital Corp. to issue short-term debt as well.

While those issues were priced off the agency desks rather than the conventional high-grade desks at the underwriting banks, and were traded off the agency desks as well, due to the government guarantee - making the bonds more like those of such government-sponsored enterprises like Fannie Mae and Freddie Mac than traditional investment-grade issues - many high grade accounts bought them, and these bonds too were seen to have moved up sharply in the aftermarket; for instance, GE Capital's 3% notes due 2011 were quoted trading around at 85 bps over; the company had priced $3.5 billion of the bonds on Dec. 4 at 212 bps over, plus another $100 million on Dec. 10 at 190 bps over, and yet another $800 million on Dec. 12 at 165 bps over. B of A's $3.75 billion of new 1.70% notes due 2010, which had priced at 97 bps over on Dec. 19, had come in to a year-end level of 64 bps over.

A trader said that such new issues, both financial and otherwise, "have moved up substantially" from the relatively cheap levels "they had to pay [to get the deals done]. Accounts have the upper hand in this game right now, they can dictate where people issue, because [the issuers] need the money."

However, he added that "that's not always going to be the case."

Another trader, also looking at the sharp gains posted by many of the various new issues that have come to market in the last month or so, a function of both investor enthusiasm as well as probably too-cheap pricing - believes that the party may be just about over on that score.

He sees a big new-issue calendar ahead, but warns that "I think the issuers, the underwriters, everyone's going to start to get a little more greedy and they're going to start coming at less and less of a concession [to the existing paper]. We've already seen that - those concessions at one point were close to 200 bps. Now the concessions are inside of 100 bps to the existings. So I do think you're going to see a further reduction of those concessions," and no more of the kind of explosive up-movements of new issues that had been seen over the last month or so of 2008.

New issues may swamp market

Looking ahead, that trader - noting that "there's been a lot of pressure for most of the year, although the last month, it's been better bid," - predicted that as 2009 opens "I think we'll see the year starting off continuing better-bid, maybe with some money put to work, the 'January Effect,' but at the end of the day, the big story is the amount of bonds you have maturing, and a huge calendar."

He cautioned that "I think that calendar is going to overwhelm things and as we've seen in previous tightening bouts over the course of the last 18 months, they're going to get a little too cute with the number of deals they are bringing, the levels they bring those deals [at], and you're going to see some balking at the absolute yield level, as we head into [2009]. That will contribute to another bout of widening. So [the troubles of the previous year] are far from over. You have a large new-issue calendar ahead of you."

A more hopeful view

Another trader took a more optimistic tone, predicting that it's his sense that "we've found a little bit of a bottom. We're going to kind of troll our way along the bottom. I think we've actually come off the bottom in a lot of ways in the past three or four weeks, especially since the Fed made their announcement," with the stronger credits "really starting to outperform" their weaker peers.

"What you had [in 2008] was the bathwater and the baby getting thrown out," as investors fled from even decent credits in the financial arena that he watches to seek the relative safety of Treasury issues when things got tough. "It was the safest bet. Then at the end of the year, November and especially through December, it's been more selective - some of the better credits are performing better, the way they should. The [real estate investment trust] paper got thrown out, and is starting to perform better - I'm seeing things like that."

His forecast is for "credit spreads tightening as the year progresses. I still think you're going to have some hiccups, maybe even a blow-up, but it's not going to hurt as much because you are, first, so far down already and second, I think it's going to be less of a surprise."

While there will still be "some downticks, you're going to have much more selective buying, and as these things shake out and you see who's still going to be around in a year or so, you're going to see a bigger differentiation between credits, where as before everything was getting lumped together."

On the new-deal front, he said that "we've been seeing a lot of non-FDIC issuance, but it was in industrials and utilities. As long as this [FDIC facility] is open, through June of '09, I see people taking as much advantage of this as they can, because why not? And some of these spreads have tightened up significantly." That, in turn, has caused some of the more recent new-deal financials to be priced tighter.

Once the FDIC bond-guarantee program winds down, "the interesting thing going forward will be to see the first financial who comes to market non-FDIC, and see how that gets priced." He expects little or no such pricing before then, barring any "positive surprises" in the spring.

By the time the financial sector gets back to pricing bonds the regular way, assuming the FDIC program is not extended, "a lot of economists feel we should start seeing or feeling some of the stimulus that has been put into place - the housing prices may be bottoming, the GDP starting to possibly get positive possibly by the end of [2009], so then it will be easier for them to issue debt [without the government guarantee] because the psychological factors will be different."

Much will depend on where Treasury rates, currently near historic lows, will be six or seven months from now.

"If rates [on Treasuries] remain this low, even if [issuers] are paying an extra 100 bps or so, the overall yield that they're borrowing money at is lower than some of their outstanding debt that they may have issued at 50 bps over. Maybe they're issuing at 200 bps or 300 bps over, but it's still a lower coupon they'll pay," due to the absolutely lower Treasury rates.

"That's an aspect to keep in mind - if the Treasury market stays in this range, then it will still be relatively cheap money for them. But that's a big "if". You could have the Treasury market down huge by June or July. So the Treasury market will be something in terms of absolute yield that accounts will need to look at, and issuers."

Financials to labor in government's shadow

One buysider who watches the financials, Bob Bishop, the chief investment officer of SCM Advisors LLC, a San Francisco-based investment company that manages $3.5 billion of assets, opined that to him "it doesn't look like after having basically bailed all these guys out that the government is going to walk away and say, 'We hope you enjoyed your trillion dollars. Thank you very much. Have at it again.'

"I think there's going to be a price to be paid and that price is going to be that they'll be required to live with more regulation. I think they'll be required to put more capital in their businesses. The return on equity capital is going to be worse - but for a bondholder, it's going to be a safer investment, much more utility-like."

While some investors have shunned the financials because of the carnage seen in the sector over the past year, Bishop is not one of them. "As a buyer, my biggest holding in investment-grade for quite a while has been financials - it's worked out great, I've missed the landmines, fortunately, and now I'm taking advantage of wide spreads and the government guarantee. It doesn't get any better as a bondholder."

Looking ahead, he said that "at some point, as things calm down, if financial institutions continue to enjoy the government guarantees and government support, they're also going to have to live with more regulation and fewer opportunities to take risk. So once again, bad for shareholders but good for a bondholder."

Infrastructure investment a good place

Back on the non-financial side, a trader suggested that some investors' reluctance to play in the financials might continue, since, in his view, "the next shoe to drop" might be any banks or other companies dealing in commercial mortgages. He noted the number of retail stores being forced out of business - "go to any shopping-center and you'll see" - and said that snowball could get bigger and put many financials, still digging out from the residential mortgage debacle, back in trouble with new damage to their balance sheets.

"I would steer clear of the bank and finance companies until everything is out in the open, we're just not there yet."

While retailing has been taking its lumps in 2008, "I don't think you're going to have a lot of the retailers perform outstandingly, but they've been beaten down so badly, they're going to get a nice rebound early in the year. I would think you're going to see that," he said.

Among the non-financial industrials, on the other hand, "with [President-elect] Obama coming into the White House, you're probably going to have some of the drug companies perform quite well," on the assumption that an expended government emphasis on healthcare coverage, one of Obama's campaign promises, could lead to more pharmaceutical purchases.

He is also of the opinion that with the incoming administration talking about massive road, school and other facilities construction as a spur to the economy, "I would think some of the infrastructure plays would do quite well, particularly companies like Caterpillar and Deere," on the assumption that increased infrastructure work will result in orders for the type of heavy equipment those companies make.

He also likes utilities. "They'll do better - not a tremendous amount better, but you'll find they're probably going to do alright. Once again, [investor] money's got to go somewhere."

At another desk, a trader said that "we had a pretty strong run this month [December]." He suggested that "we could see a little pullback at the beginning of January as the rest of the retail numbers come in, but then I think you'll see [it get back to] a gradual tightening mode.

He said he "would not be surprised" if the average spread on investment-grade bonds got to be 200 bps tighter than the peak spread levels of late November.

He said the market could continue to draw some strength from the recent Fed announcement, particularly the central bank's pledge to continue to prop up the economy and support the credit markets going forward, using all of the many tools in its bag, now that lowering interest rates that it can control by fiat has run its course.

"There's some confidence that, 'We [the Fed] are going to do everything possible, guys, so get back in the market, buy some debt, loan some money - we're going to be there for you.' It changed the perceptions of things, which is a bigger thing; the market is the market - but perception and psychological factors in this market are huge."

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