With yields and spreads widening to 2010 levels, US leveraged finance markets are pricing in an increased likelihood of another recession in the world’s largest economy. However, investors are confident that high-yield borrowers’ balance sheets will withstand slowing growth and they expect defaults to remain below 2% this time around.
US high-yield bonds have been among the most resilient fixed income asset classes since the Lehman crisis. While leveraged loan supply continued to plummet until the Federal Reserve’s quantitative easing programme put a floor under credit risk appetite in 2010, the high-yield bond market has grown each year since 2008, according to data from Thomson Reuters.
From a low of US$39.4bn across 95 reported trades in 2008, US high-yield borrowers issued US$145.7bn in 2009. A combination of negative real interest rates, more asset purchases by the central bank and improved corporate fundamentals drove high-yield issuance to US$263bn from more than 540 transactions in 2010, its highest ever level. Furthermore, investors shrugged off European sovereign contagion concerns to absorb another US$181bn of new risk this year, equivalent to a year-on-year growth rate of 20%, according to Thomson Reuters.
Although the volatile summer has undermined primary and secondary market momentum, and US high-yield spreads have widened by some 250bp from the annual tights of Treasuries plus 500bp set in April, investors maintain that the market got it wrong. Ann Benjamin, head of leveraged asset management at Neuberger Berman in Chicago, manages a US$18bn leveraged credit portfolio. She says default rates will remain below the long-term historical average for the next few years at least.
“Clearly the market has been volatile and spreads have widened significantly over the year but it continues to present a strong value opportunity. With spreads at plus 750bp, the market is pricing in a high default rate which we don’t think will materialise,” she says.
Flow slows
Notwithstanding corporate America’s robust fundamentals, with spreads giving up most of their gains of the past twelve months in recent weeks, and tight conditions in primary and secondary markets, high-yield is now focused on the systemic consequences of a potential Greek default.
After a forebodingly quiet summer, with no new issues in the last two weeks of August, the prognosis for the remainder of the year is a difficult one. Despite qualified enthusiasm for the first deals of September, including an increased seven-year from Double B rated healthcare provider Fresenius Medical Care, which cleared at the tight end of guidance at Treasuries plus 533bp, dealers are unlikely to seriously test market liquidity and risk appetite until the headline risks are either dealt with or recede.
Indeed, while the US leveraged loan forward calendar included more than 30 transactions worth more than US$13bn at the beginning of September, the bond market expects just one new trade from Single B rated manufacturer JELD-WEN, according to JP Morgan high-yield strategists.
“The primary market slowdown has been greater this summer than normal, and we have seen the lightest new issuance in August since 2008. We are looking for a pick-up in activity and only time will tell if that’s too optimistic. The market needs the headline risks to move to the backburner, and once investor confidence around the outcome in Europe improves, new issuance activity should also resume,” says Peter Acciavatti, head of high-yield strategy and research at an investment bank in New York.
Europe vs US
Of the two headline risks sapping investor confidence, Europe has the greatest potential to derail the high-yield risk-on rally. Although US macroeconomic data continue to disappoint and have increased the likelihood of a double-dip recession, high-yield borrowers have made extensive use of the strong bond and loan investor demand to refinance capital structures and deleverage balance sheets.
JP Morgan estimates, for example, that leveraged finance borrowers have applied as much as two-thirds of the total bond and loan proceeds of the past three years to refinancing, with less than one-fifth funnelled into acquisition finance or LBO activity. By comparison, leveraged credits used more than 50% of bond proceeds to finance LBO activity in 2007.
The European issue is less tractable. The Greek default has raised questions about the capitalisation of the European banking system, and memories of 2008 are never far from the mind. US credit metrics across cash and derivative markets have widened in response to heightened risk sensitivity, and US dealers have dramatically reduced their exposure to corporate bond markets. A lack of confidence in political actors to solve financial problems is widespread.
“While the potential systemic contagion arising from the Greek sovereign crisis is a tail risk, it is one with an increased likelihood given the current situation in Europe. The political risks of getting the various players on the same page to come up with a larger, more comprehensive plan to deal with the funding problems in Europe is hurting confidence,” says Acciavatti.
Recent dealer inventory data published by the Fed lend support to the assertion by investors that dealers have pulled back from market making, albeit temporarily, and that liquidity in both primary and secondary markets is at its lowest since the darkest days of the crisis. According to the Fed’s Primary Dealer Positions index, which shows dealer holdings of various classes of fixed income securities, including corporate bonds, dealers have reduced inventories significantly since late May, when the index of corporate securities holdings longer than one-year reached its annual high of US$92bn. Between June and August, the index fell US$27bn to US$65.2bn, a level last recorded in April 2009, according Bloomberg, which publishes the index.
Although not yet at the stage of a full blow unwind, Charlie McCarthy, US MD of High Grade trading at BlackRock in New York says that after a summer of unfortunate headlines in the US, credit investors have tempered their expectations for a swift resolution to headline risks at home and abroad with the result that most are now looking for a higher return.
“The lack of liquidity provided by banks, combined with the negative outflows in the high-yield mutual fund space has amplified the price action. Against the slowdown in the global economy, and continued uncertainty in Europe, people are now expecting a higher return to invest in US credit,” he says.
The anaemic bond forward calendar, combined with the warning signs in the dealer inventory data suggest a hiatus in bond origination. Leading high-yield underwriter by market share, Barclays Capital, declined an invitation to be interviewed for this article.
US retail overdoes it
US retail investors will be a key factor in determining whether high-yield regains its swagger in the fourth quarter. Although inflows have exceeded outflows year to date by US$800m, retail investors yanked nearly US$6bn from high-yield mutual funds over the summer, according to fund data provider Lipper, a unit of Thomson Reuters. However, the first two weeks of September saw this trend reversed with net inflows of US$780m, as spreads at 2010 levels enticed investors back to market.
The tendency of retail investors to overshoot upward and downward market moves creates opportunities for other market participants who have used these volatile technicals as potential buying indicators should the opportunities offer meet their portfolio criteria.
“Mutual fund flows tend to drive spreads, and outflows can create buying opportunities. If the funds experiencing outflows decide to sell the higher quality names that we like, we might go back in and pick up selected credits at attractive spreads,” says Neuberger Berman’s Benjamin.
Comfortable with the risk
With spreads now in the Treasuries plus 750bp area, markets now imply a default rate of more than 7%, according to JP Morgan, although realised corporate defaults currently stand at 1.1%. The divergence between fundamentals and crisis-mode market valuations is sharp and should ensure that spreads resume their tightening pattern as markets normalise.
BlackRock managing director and leveraged credit portfolio manager Leland Hart says that while the risks remain elevated, the relatively low opportunity cost of staying in cash or Treasuries has been an advantage. “No one wants to make decisions based on daily volatility. Fortunately, the outperformance of cash and Treasuries has given us some breathing room. If the opportunity cost is zero, then I can take my time and see what’s out there,” he says.
“If the headline risks begin to appear more manageable, risk appetite will return and more capital will flow into high yield, which will lead to more flow from high yield capital markets. If the risks get worse, there’s not much that bankers can do other than offer higher and higher yields to entice investors back. It’s a delicate moment,” says Acciavatti.
The immediate future of the risk-on trade remains in the balance.
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