Junk Lives! High-Yield Bonds Open 2012 Strong

Spreads have come back to earth for issuers, as investor appetite for the asset class returns.
Vincent RyanFebruary 10, 2012

High-yield credit markets have recovered from their near-paralysis in the final months of 2011. That’s good news for issuers and investors, as long as the European debt crisis and unexpected hiccups in U.S. economic growth don’t derail the market.

In January, U.S. corporations rated as speculative-grade issued $22.8 billion in debt, according to the Securities Industry and Financial Market Assn., two-thirds of the dollar volume of junk bonds issued in the entire fourth quarter of 2011. That represents a healthy recovery from the early fall of last year, when issuance fell into the single-digit millions.

The market sent other positive signals this week: casino owner Caesars Entertainment priced a $1.25 billion senior secured junk-bond deal on Thursday, and hospital operator HCA sold $1.35 billion of speculative-grade paper on Tuesday.

Junk-bond spreads have tightened since their highs of October 2011, when they surpassed 900 basis points. Standard & Poor’s reported Friday that speculative-grade spreads for U.S. companies narrowed to 647 basis points this week. That’s above the one-year moving average of 617 basis points, but below the five-year moving average of 711 basis points.

“If I were a CFO and looking at my capital structure I’d be looking to take advantage of rates,” says Gautam Khanna, a managing director of portfolio management at Cutwater Asset Management. “Why not bring down your cost of capital by issuing in this market?”

High-yield paper is also attractive to investors. “We’ve had a robust start to 2012 — with high-yield bonds up over 4% — and it’s indicative of investors saying that they are not so sure about what the equity markets have in store,” says Khanna. “Volatility could still shine though.”

Issuance volumes in high yield will largely be supported by companies refinancing, but not as much as in past years, says Mariarosa Verde, a managing director at Fitch Ratings. “Roughly 50% of issuance was related to refinancing in January, but that’s down from a recent high of 65% in 2009,” Verde says. “In both 2011 and at the very start of this year, more issuance has been dedicated to M&A, leveraged buyouts, and funding capital expenditures.”

The economy will be the driver if that kind of high-yield bond issuance is to continue through 2012, says Verde. “If we continue to see [economic] progress, there will be a greater emphasis on growth-oriented activities and that will necessitate additional borrowing,” she says.

One wildcard is the European debt crisis, which could ignite a bout of risk-averse investing. The second is an increase in corporate default rates.

Last quarter, downgrades affected 5% of outstanding corporate bonds, says Fitch Ratings, the most in one quarter since 2009. In the entire second half, downgrades hit 7% of bonds; 1.9% experienced upgrades. The only consolation was that a vast majority of the downgrades were for debt issued by banks, according to Fitch, as overall bank credit ratings continued to slide.

Fitch is forecasting that the overall corporate default rate will be in the 2.5% to 3% range by the end of this year, compared with a 1.5% rate at the conclusion of 2011.

“Defaults are driven by both macroeconomic factors and by company-specific challenges,” says Verde. “In the recent batch of defaults, it is the latter that is emerging as the culprit. Defaults are coming from weak companies that perhaps raised additional debt as recently as 2010 and 2011 but simply can’t make it given either outdated business models, sensitivity to cautious consumer spending, or deeply competitive industry dynamics.”

Still, based on where high-yield bonds are priced now, investors have a big margin of safety, says Khanna. Market pricing is implying five-year cumulative default probabilities of 40%, Khanna says. But the five-year cumulative default rate hasn’t been north of 40% since the Great Depression. As further comparison, this number hit 35% during the dot-com bust and 33% during the savings-and-loan crisis, Khanna says.