December 15, 2015
By Matthew Fuller
In the wake of this year’s bruising decline of roughly 5% for high-yield bonds, estimates for high-yield bond returns in 2016 range from a loss of 3% to a gain of 6%, according to an annual, informal survey from LCD. More troubles in Energy and Mining, as well as the potential development of a U.S.-led economic downturn, will likely weigh on returns next year, market observers say.
Single-digit returns are unusual for the high-yield market—double-digit swings in either direction are more common. Matt Freund, senior vice president of portfolio management at USAA Investment Management, expanded on the lackluster returns. “Tremendous defaults are coming in high-yield energy, but we think that’s already reflected in current pricing.
But if [the defaults] spread to pipelines, services, etc., it would catch the market by surprise,” Freund said. Freund also noted that other wildcards that could trigger a bigger move include a policy mistake by the Federal Reserve or a recession. However, neither of those scenarios are USAA’s official view.
Returns in 2015 through Dec. 14 are negative 5.15%, down from negative 1.44% just two weeks ago amid this month’s rapid deterioration. There hasn’t been a negative annual return since the supersized loss of 23.4% in 2008 amid the credit crunch, according to the S&P U.S. High Yield Corporate Bond Index (SPUSCHY). The current reading is a 7.79% delta to last year’s positive 2.65% return and missed all Street estimates for “below-coupon” returns ranging from positive 2.5–6.5%.
Looking ahead, prominent bank forecasts range marginally on either side of the unchanged mark, from both negative to positive in the low- to mid-single digits. On the downside, albeit barely, Deutsche Bank projects a negative 1% return. Bank of America is the most pessimistic, at negative 2–3%.
“Global weakness, improving fundamentals, and cheap valuations [are] good catalysts for [investment-grade] credit, we actually think all three of those factors are to the detriment of high yield in 2016,” according to Michael Contopoulos, head of high-yield and leveraged loan strategy at Bank of America Merrill Lynch. On the upside, Credit Suisse forecasts returns of positive 6% next year; J.P. Morgan projects 5–6%; Morgan Stanley lays out 5.1%; and Barclays predicts returns of 4–5%, according to the LCD survey. RBS forecasts a positive 0.4% return.
“If it becomes clear that the business cycle is not facing an imminent recession in developed markets, we think spreads should rally modestly, helped by accommodative central banks outside the U.S.,” offered Barclays strategists in the annual outlook.
Last year’s wildcards proved disruptive. The bear-market mauling in the oil patch worsened. Additionally, the historically loose monetary policy didn’t end as expected, as several weaker economic data prints kept the Fed on hold with rate-hike lift-off until December, as compared to expectations of March 2015 at this point last year.
As with 2015, market participants don’t expect tighter monetary policy to roil high-yield, assuming it’s at a measured pace.
Regarding interest rates, most prognosticators in recent years have jumped the gun in predicting a bear market for U.S. Treasury notes. Respondents to last year’s informal annual survey by LCD projected the yield on the 10-year Treasury note to be from mid-2% to just under 3%. It now sits below that range, around 2.25%, the same as a year ago, albeit at the higher end of the 2015 range from approximately 1.65% in January to 2.5% in June.
Looking ahead, forecasts are again for a context of nearly 3%. RBS projects 2.85%, and Credit Suisse 2.95%. One standout is Deutsche Bank, which lays out flat 10-year yields for 2016.
This year, higher-quality BB paper was a safe haven, essentially unchanged against the broad market downdraft, but how would notes fare in the long-forecast rising-rates environment? Certainly low-coupon paper is sensitive—think Ball Corp. 4% notes due 2023 and Constellation Brands 4.25% notes due 2023—but investors see plenty of room for compression.
“There is a pretty good cushion to rising rates for BBs averaging about 6%,” offered Freund.
To that end, the BB tier within SPUSCHY as of Dec. 14 offers an average yield of 6.38%, up from 5.61% two weeks ago, and an average option-adjusted spread of T+466, up from T+398 two weeks ago, versus 4.91% and T+332 at the end of 2015.
Bankers relay ongoing concerns about the regulatory environment put in place nearly three years ago, and that the tighter restrictions may continue to reduce leveraged-deal making, as they did in 2015. There was about $8.6 billion in buyout-related high-yield issuance this past year, for roughly 3% of supply, down from about 4% of supply last year and nearly 6% of supply three years ago.
In contrast, there was $90.3 billion of corporate M&A issuance this past year, for approximately one-third of annual output, down from about 29% of supply last year and 16% dating back three years, according to LCD. Moreover, the shadow calendar for high-yield is roughly $23 billion, with just 13% of the sum LBO-related, and the balance M&A.
Greater high-yield issuance is forecast for the year to come, as well as an expansion of the non-investment-grade space due to fallen-angel downgrades in the commodities sectors tempered modestly by the elimination of debt with commodities bankruptcies.
Mining giant Teck Resources this past month, for example, brought $4 billion of supply to the high-yield market after its downgrade to BB, from BBB–, and it now represents 0.24% of the SPUSCHY. (The transitions from investment-grade to high-yield indexes occurred in November.)
Away from fallen angel supply, prominent bank forecasts for U.S. high-yield new issuance in 2016 range from $200–300 billion. This compares to a pro forma domestic and Yankee speculative-grade corporate supply of $263 billion for 2015, which is at the lower end of the $260–340 billion consensus forecast range put forth one year ago, according to the LCD survey.
Among the forecasts are a steady-as-we-go $275 billion out of J.P. Morgan and an unchanged-to-higher prediction of $270–290 billion out of Barclays. A few outliers in the informal survey include Morgan Stanley, which put forth an estimate for a roughly 10% increase, to $296 billion; Wells Fargo, which for a second year is calling for roughly a 25% slowdown, to a $225 billion context; and both Bank of America and Deutsche Bank, which are pegging less, at $196 billion and $210 billion, respectively. Of note, Credit Suisse, which this year essentially nailed the number, at $260 billion, opted against a follow-up forecast.
Looking ahead, the shadow calendar was whittled down this past month with the big Charter Communications and Constellation Brands M&A deals done and dusted. With those and a few other smaller offerings cleared from the backlog of business, pro forma volume on the shadow calendar contracted to roughly $23 billion. Some of the names recently added include a $1.05 billion TreeHouse Foods M&A bridge to bonds, $1.8 billion backing the Solera/Audatex buyout, and $2.3 billion backing the Veritas buyout, even as the loan effort was postponed last month due to market conditions.
The crux of commodities
By all accounts, commodities will headline 2016, barring exogenous shocks and geopolitical turmoil. Whether the view is to avoid the trouble in the oil patch and mining, or scour these spots for opportunities, it’s a hard part of the market to avoid. Indeed, these sectors represent 18.62% of the SPUSCHY: 15.90% Energy, 1.40% Mining/Metals, and 1.32% Steel.
Investors are positioning for continued low oil prices after this year’s plunge in prices surpassed even the worst bear-market scenarios. Prominent forecasts are for at least another year of oversupply in the sector. The lack of policy adjustment out of OPEC fans the flames.
As for the disruptive effects of the advent shale-drilling technologies, the question is “How long can this strategy go on for OPEC?” says Jon Adams, senior investment strategist for BMO Global Asset Management.
“Our case is that the sell-off in August and September was more sentiment-driven, and less fundamentals-driven, so we see some attractive value for the medium term. It’s been a difficult few weeks here as high-yield diverged from equities, but the implied default rate of 7–8% ex-Energy is implying a recession, and in our view we are only mid-cycle,” furthered Adams.
Credit analysis has therefore turned to separating the “haves” and “have nots” by production region, costs, and margins, as well as evaluation of the infected services providers, and credits across Metals and Mining sectors.
“As the cycle bottoms, you have to look at the high quality and low cost producers. Those are the ones that are going to attract attention. The problem is that they are not necessarily high-yield. They are the low-cost investment-grade natural gas plays,” according to USAA’s Freund.
“[In high-yield Energy] you are going to go through a long period of defaults and consolidation, but the big integrated oil companies and private equity will wait for oil to bottom, and that’s not going to happen right away,” Freund added.
Away from M&A in the space, issuers will find solace in the courtrooms and through sideskirting bankruptcies through privately negotiated exchanges. Many were completed this year, including uptier swaps from the likes of American Energy – Woodford, Midstates Petroleum, Venoco, Warren Resources, and Linn Energy, and debt-for-equity exchanges for Halcon Resources and SandRidge Energy.
As for these efforts and their efficacies, USAA’s Freund says: “We view them bond by bond and company by company. We have participated in some, and not in some. Being more cautious about our allocations has helped.”
Two late-year marquee transactions were the uptier exchanges from California Resources and Chesapeake Energy. The former’s was greatly oversubscribed, with $3.653 billion of its three series of senior notes totaling $5 billion put in for the deal. Unfortunately for investors, it leaves an approximate 56% balance of each series’ less widely held, less liquid, essentially “stub” paper that is subordinated to the new issue. As such, all three are wallowing in the high 30s, down from the low 60s after the effort launched to market in mid-November, and the low 70s prior, trade data show.
Chesapeake’s long-awaited plan for an uptier of its deeply distressed unsecured bond issues into an up-to-$1.5 billion new issue of 8% second-lien notes launched Dec. 3, and early participation is due at 5 p.m. EST today, Dec. 15. The overarching transaction, which has been rumored for weeks as bonds plunged to record lows and peers launched similar exchanges, is the largest of its kind by tranching, covering 10 series of Chesapeake Energy senior notes, including one euro-denominated series and a floating-rate note.
It’s based on a six-tier priority scale, with consideration ranging from a par-equivalent swap for the tier-one euro notes, down to as low as a $565 per-bond equivalent for the 4.875% notes due 2022 in a four-bond, tier-six grouping, according to a company statement. Even so, those 4.875% notes have plunged this month amid the sell-off, with recent quotes of 25/27, sources said.
The way forward
Looking ahead, clearly the focus is avoiding the commodities crunch, and the BB trade is getting a little crowded. Away from the Chicken Little reports in the broadsheets circulating of late—high-yield is signaling recession, high-yield is portending a sell-off in equities, Energy bonds are the new subprime—seasoned market professionals see value in the marketplace, if not strong opportunities.
“We see opportunities in the first quarter to pick up on non-energy sectors that have repriced, and credits that have cheapened, but you have to be actively managed. You don’t have to traffic in the dicier sectors, which will be trouble for years to come,” according to Art DeGaetano, chief investment officer of Bramshill Investments.
“We are dramatically underweight energy in terms of E&P, but tremendously overweight in pipeline. There are opportunities in crossover BB and BBs and fallen angels,” confers USAA’s Freund. “We are modestly overweight high-yield across our portfolio strategies since early October. Our view is that the sell-off in August and September was more sentiment-driven, and less fundamentals-driven, so we see some attractive value for the medium term,” explained BMO’s Adams.
“One thing is for sure, junk bonds will exist after this period of media-induced fear and regulatory liquidity constraints. It’s never pleasant for those caught offsides, but rest assured that those investors with patience and capital can earn better-than-equity-like returns if they remain rational in their approach to the opportunities,” summarized a veteran salesperson who wished to remain anonymous.
The U.S. trailing-12-month speculative-grade corporate default rate ticked up to 2.8% in November, from 2.7% in October and 2.5% in September, according to S&P Global Fixed Income Research (S&P GFIR). The current observation is the highest reading since it was equally 2.8% in October 2013. At the same time, the S&P U.S. distress ratio increased to 20.1% in November, from 19.1% in October. It’s at the highest level since it hit 23.5% in September 2009 amid the financial crisis.
The S&P GFIR forecast for the U.S. speculative-grade default rate is for a modest increase, to 3.3%, by September 2016. In contrast, prominent bank forecasts are mostly higher. J.P. Morgan is under that context on average, at 3%, but then breaks out at 10% as a standalone default rate for the Energy sector. Credit Suisse is a bit lower, at 2.5–4%, and RBS is modestly higher, at 4.6%. Barclays is forecasting a 5–5.5% default rate, with a range of just 4.4% if oil prices rise to $60 per barrel or more, and to 6.4% if oil sinks below $40 per barrel.
Certainly defaults loom in the sector, as well as in Metals & Mining, but note that the LCD restructuring watchlist has many other names. Retailers Bon-Ton Department Stores, Claire’s Stores, Elizabeth Arden, Gymboree, J. Crew Group, and restaurants company Logan’s Roadhouse line the docket. Back in commodities, Arch Coal is the most pressing, as it skipped the large, multi-series coupon payments due today, Dec. 15.
Meanwhile, LCD’s shadow default rate—a measure of performing S&P/LSTA Index issuers that have (1) missed a bond payment, (2) entered a forbearance agreement, or (3) hired bankruptcy counsel—has climbed to 1%, from 0.84% as at the end of October. By amount, $8.54 billion of Index outstandings are on the shadow list. The publicly known loan issuers are Arch Coal, Gymboree, Millennium Health,R.H. Donnelley/SuperMedia/Dex Media, Paragon Offshore, Peabody Energy, and recent addition Verso/NewPage.