New Issue "Premium" and its Relation on Secondary Prices

Before I get to the meat of this post, I would like to highlight to readers a very interesting quote from Jeffrey Gundlach, legendary bond investor and founder of DoubleLine Capital, in an interview with Barrons:

"Gundlach's cautious take on high-yield is the result of an aperçu or intuitive flash he had several weeks ago, that the yield spread between high-yield and government bonds should be calculated using the 20-year government bond, rather than the entire Treasury yield curve. That's because high-yield paper, though maturing sooner than 20-year bonds, shares similar price volatility. The current 300 basis-point, or three percentage-point, spread between yields in the high-yield market and on 20-year bonds is as narrow as it has been at any time in the latest credit cycle, he notes."

While I do not have the data in front of me, this is an interest pronouncement and echoes my feelings that credit markets (high yield/bank debt/distressed [to a lesser extent]) are overvalued. I do not know if it will be next week, or next month, or even 2013, but I believe an investor is not getting compensated for taking risk in the leveraged finance markets. Unfortunately, the primary market, being as wide open as it is allows speculative issuers to extend their maturities out hence lowering the near term expected default rate which is bullish for credit.

According to JPM's Peter Acciavatti: "As such, institutional loan issuance is tracking at an annualized pace of $320bn, versus the previous record of $387bn in 2007 (predominately in 1H). When combined with $62bn of high-yield bond volume YTD, total leveraged credit new-issue volume is tracking at an annualized pace of more than $640bn, versus $457bn in full-year 2010."

That is a lot of credit.

Any issuer would be foolish right now not to aggressively reprice their bank facility or significantly relax (or remove) covenants. And every banker is out there telling CFOs and Treasurers: "If at any point is there a time to do a big M&A / debt financed stock buy back / stuff coffers, now is the time." Private equity is salivating at financing costs, so much so, that a good friend of mine at one of the most respected private equity firms out there said they have to step back from deals because sponsors are getting irrational with multiples justifying cheap leverage.

To the point of the post: Despite the large number of deals across the rating categories, the enormous inflows of capital from the retail and institutional side seem to be dwarfing them where most deals are still widely oversubscribed (this is the case in IG as well, possibly more so). Some deals have not fared as well (JNY 6.875% for instance), but most "better quality deals" have effectively turned into a food fight. And, more so than I can remember in recent pasts, dealers are putting out "whisper talk" substantially wider than where deals are pricing - to the tune of 25-50 bps back from secondary trading levels.

What is happening though, is that these better quality deals are getting priced INSIDE secondary trading levels. This creates a tightening of the entire complex which seems counterintuitive (i.e. more debt leads to more leverage leads to higher default probability). Furthermore, these new tighter prints then become relative value comps for issuers in the same industry tightening up more credit along the line.

As spreads tighten across capital structures and across the industry (for equivalent rated bonds), high yield returns increase. Higher ex-post returns, again counter intuitively, lead to more capital flowing to the space which exacerbates the cycle with primaries printing at even tighter levels.

You would expect that as the syndicate desks tightens up pricing there would be significant amount of "drops" to come to a more reasonable supply / demand balance. The problem is, many investors (I have been guilty of this in the past), have done the work on the issuer and will "suck it up" and take the 25-50bps cut in yield despite the offering not being priced as attractively as before. Further, as a nice chunk of the leveraged finance deal making YTD has been refinancing, funds that want to maintain exposure to certain issuers need to make sure they get their bonds - they will pad their orders creating a situation that many value investors do not like to find themselves in: Irrational / uneconomic buyers. Buying for technical reasons is irrational and will create price movement errors on the upside.

I much prefer buying from irrational/uneconomic sellers that sell a stock because it was kicked out of an index, or because a bond got downgraded to CCC, or a company is filing Chapter 11. In those instances, the "technicals" are working for me, my potential return has increased, and my potential downside has decreased. That is the opposite of the credit markets today. I hate to use the term "bond pickers market" (it sounds ridiculous), and instead will use the term "avoid land mines market" Shorting the credit market in aggregate while selectively playing credit stories you believe in and waiting for uneconomic sellers to arise throughout the year is the prudent way to navigate this market. For those interested, and I will do a post on this at some point, I think buying protection on certain tranches of either HY CDX tranches (or the vanilla HY15 index itself) or certain tranches of the IG15, which is much cheaper, and has greater skew (cost versus upside) makes sense, especially for those interested in tail hedges.

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High Yield Record

Over the past few days, I read a number of stories about high yield debt issuance for March 2010 being an all-time record. From Bloomberg:

March 29 (Bloomberg) -- Junk bond sales reached a record this month as rising profits and record low Federal Reserve interest rates foster lending and investment to the lowest-rated borrowers.

Companies worldwide issued $38.3 billion of junk bonds in March, passing the previous high of $36 billion in November 2006, according to data compiled by Bloomberg. Yields fell 0.95 percentage point to within 5.96 percentage points of government debt, the narrowest gap since January 2008, Bank of America Merrill Lynch index data show.

This is “an almost ‘Goldilocks’ environment for leveraged credit markets,” JPMorgan Chase & Co. analysts led by Peter Acciavatti, the top-ranked high-yield strategist in Institutional Investor magazine’s annual survey for the past seven years, said in a March 26 report to the bank’s clients.

Sales soared as investors plowed a record $33.6 billion into speculative-grade funds this quarter, according to Cambridge, Massachusetts-based research firm EPFR Global. Bonds of Stamford, Connecticut-based Frontier Communications Corp. and Consol Energy Inc. of Pittsburgh, which sold a combined $5.95 billion of debt last week, rose about 2 cents on the dollar to 102 cents.

That’s a turnaround from February, when companies canceled sales at the fastest pace since credit markets began to freeze in 2007 amid concern that the inability of European governments to trim their budget deficits will threaten a global recovery.

In February, I wrote a post about the weakening of the high yield market. This month feels the exact opposite. 95% of deals are well oversubscribed (similar levels in the loan market). From a bottom's up perspective, it is becoming increasingly hard to find value in the corporate space. It feels sort of like Jan/February 2007 when you would look out on the primary market/second market and know that it couldn't sustain itself - we would always ask the sell side: "What stops this train?" And most of them said, "We just don't see it stopping..." How did that work out for you?

Unfortunately, the momentum is self-fulfilling prophecy in an asset class like high yield. People read about returns, throw money into the asset class, bid it up higher, more articles, more capital, rinse/repeat. I did a poll of DDIC members on their expectations for the 2010 return on high yield. Over 80% believed it would be less than a 5% total return. Is that attractive? Maybe if you are comparing it to sub 50 bps savings accounts, and still quite low treasury yields.

As a contrarian, I am usually early leaving a hot market. When I read article after article about how great the high yield market is, I become more tepid about allocating capital to the space. Am I short? Not terribly - CDS on certain IG names looks very interesting for the optionality. Am I completely out of the market? Absolutely not - There are still a few interesting distressed debt, post-re org equities, and merger arbitrage opportunities that have offer a sufficient upside, with limited downside, combined with a catalyst. That is still where we like to allocate our capital.

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The Debt Market

Over the last week or so, I have received a number of emails from readers asking my thoughts on the current debt market. Most of these questions really refer to the state of the primary debt market so I will focus on that for this post specifically. The secondary is a whole other issue, but for now, let's try to dig in and see what is happening in the primary debt market.

Before we begin, we need to segment the market into three baskets. These baskets are quite broad obviously, but for the time being will serve us fine:

1. The high yield bond market
2. The investment grade bond market
3. The levered loan market

We participate in all three markets. Last week, AMG reported their mutual fund flows for the week ended February 10th. Here are the relevant statistics:

High Yield

• Outflow of $984M this week
• YTD inflow of $2,246M

Bank Loans

• Inflow of $195M this week
• YTD inflow of $1,691M

Investment Grade

• Inflow of $692M this week
• YTD inflow of $24,070M

So, the only real outflow was the weekly data for high yield. And empirical that's how it feels in the market right now. We have seen a lot of new deals being postponed or pulled in the high yield market. And the high yield deals that did get done are definitely trading weaker. For example, Freescale issued a 10.125% bond last week, which priced at par. On the 9th of February, after the deal was closed, I saw a market of 100.75/101 (i.e. the dealer will buy from you at 100.75 and sell to you at 101). The last run I saw on Friday was 98.625/98.875.

Now, that might not seem a lot to readers, but most new issues were trading at least a point or two above the break up through January. That, in tandem, with quite a few new issues being pulled (Songa, Bombardier, etc) spells some trouble for the high yield market. You also have exogenous events like Travelport pulling their IPO which sent bonds down 6 or 8 points depending on the tranche, and you get even more skiddish.

Why is this occurring? I couldn't give you a specific reason but my guess is that investors are ratcheting up risk premiums in light of what is going on with the PIIGS. Higher credit spreads are needed when everything is riskier right?

Investment grade is another story. To me, it seems like the IG market, despite the index nearly trading back to par (the IG13's got as low as the mid 70s in January) still feels pretty strong. Obviously PIIGS risks have sent spreads leaking higher, but new issue's are still trading quite strongly. Kraft did a big deal last week (had to relaunch it 5 bps back) and priced the 16s at 190 over. They went out on Friday wrapped around 178. And yes, maybe Kraft issued well wide to get a strong syndication, but quite a few of the new issue high grade companies are trading well through new issue prices.

I'd have to say the same for senior secured bank debt. SSCC's new term loan is trading above OID. Six Flag's exit facility is trading a little bit weaker, but not materially. Some of the smaller new issues in the bank debt market are trading quite well. From everyone I talk to in the street, CLO's still have money to put to work with so much paper being refinanced into the senior secured bond market and their reinvestment windows not expiring until 2012-2014 depending on the vintage.

So net/net? Investors are asking for more risk premium and are allocating more capital to safer asset classes (high grade and levered loans) at the expense of riskier assets like high yield. One could also argue that high yield had such a monstrous run that something had to give. Most of the people I talk to were de-risking going into the end of the year and even through January. I do not have a sense whether the street is long/short right now - everyone is playing their cards pretty close to the vest. Obviously IG is the home run trade if the curve tightens from here as investors seek the safety of the U.S. treasury relative to risk assets. Unless of course credit spreads widen significantly on a double-dip recession. Like I noted in a previous post, I wouldn't want to ratchet up the risk at this point in the cycle - lots of us made money in 2009, and want to conserve our investors capital when better, more juicy opportunities arise, possibly in the 3rd or 4th quarter of this year.

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Was that a top in the high yield market?

On January 27th, I wrote a post in the Distressed Debt Investors Club Forum (available to members only) entitled: "Top?" in which I commented that if the Ryerson's discount note offering, that was used to fund a dividend to Platinum equity, priced to yield a little over 16% was not excessive, then I really do not know what is.

Members of the DDIC have known I have been bearish for the last few months. When new issue market is a storming, I go a-running. We have played probably 15% of the deals that have come to both the high yield and leveraged loan markets in the past three months. Now admittedly, when the market started to open up in June, some issuers were bringing reasonably priced deals to the market with reasonable covenant packages.

Then things got ugly.

But, as investors, we are the only ones to blame. You can't blame the issuers: They want to lock-in long term financing that is anything but restrictive. You can't blame the bankers: They want to lock in their risk less fees. And you can never blame the sponsors: They are the ones that will suck high yield and leveraged loan investors dry if they get the chance.

In November / December, new issues were breaking two or three points above new-issue price. And then everyone was playing the flip. And order books continued to swell - and larger funds (including index funds) had to pad their orders to get the allocation they wanted / felt like they deserved. And the order books swelled some more. Vicious cycle. And as a high yield investor, you look at these new issues trading at 105 or 106 and say: "Where did I/we go wrong here"?

So, I have continued to focus my attention back to distressed / stressed high yield and other ancillary opportunities where the upside/downside is better suited than buying a poorly structured, deeply subordinated high yield bond. In addition, I have really laid into my shorts over the past few weeks. Wouldn't mind a correction to hit the reset button on all these easy money made over the last five or six months.

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Maybe I should call the blog "High Yield Investing"

Earlier today, Peter Acciavatti, J.P. Morgan's head of High Yield Strategy gave a presentation at JPM's 2010 US Fixed Income Outlook Conference. Some key take-aways from the call:

• High yield and leveraged loans remain attractive with solid expected returns. He pointed to a slide a ~12% expected return for high yield and a ~13.5% expected return on leveraged loans.
• These returns are driven by spread tightening, modestly offset on the high yield side of the world by the treasury curve widening (bank debt is floating and hence would not be negatively affected by rising rates)
• In the high yield market, demand has modestly outpaced supply. In loans, demand is dramatically higher than supply due to limited levered loan issuance this year.

The saddest slide for me, and I am sure my readers, was one pointing out how small the distressed universe is right now.

In November of 2008, there was over $230B of corporate debt trading below 50% of par. Today there is less than $10B. As a percent of the market, 31.4% was distressed in November and now only approximately 1%. Hence the reason for the title of the post: There is no more distressed - just a lot of high yield.

What compounds this situation, which Peter correctly alluded to in his presentation, is distressed funds have had a huge year. A huge year is generally followed by capital raising - more capital to the distressed space means asset prices being bid up and IRR's decreasing.

Of course, as mentioned in previous months, I believe this is a long drawn out cycle and distressed debt will return in force when the wall of maturities in 2012, 2013, and 2014 begin to tumble onto a weaker market where structured credit buyers are no longer forceful participants. But it could happen sooner if economic growth continues to be lukewarm at best. To position myself I am buying event-driven names with a definite catalyst: Six Flags' bank debt for instance, which was weaker earlier in the week on a new plan by the HoldCo note holders (full write-up at the DDIC).

John Hussman puts it best:

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

Maybe I would not use the term "terrific second act." Though if it happens soon, it will surely be bad for all those buying CCC+ bonds at a 11% yield.

More high yield versus distressed debt posts in the future? Given the animal spirits in the market these days, I'd would venture a disappointing yes.

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