Investors buoy up US high-yield

THE END OF December is customarily a time when the primary markets are winding down in advance of the holidays. It's when syndicate heads have a chance to get together for a pre-Christmas celebration and look forward to taking some time off work.

There was no such luxury for those working in the US high-yield market at the end of last year. The market tends to get quieter after Thanksgiving but this time the pace of new issues accelerated.

"December is usually a moderate month but it could end up being the busiest of the year," said Mike Meyer, managing director and head of leveraged finance debt capital markets at Bank of America, in mid-December. "The previous high was $15 billion in a month, but we've done well over $10 billion this month, we're doing more deals this week and there are more coming next week right up until Christmas." And that's not the end of it. "January could be very busy and could break all records," he added.

All this unaccustomed activity marked a storming end to the biggest ever year in the US high-yield market. As Euromoney went to press, total volumes of new issuance had already surpassed the previous record volume years of 1998 and 2003, when the market clocked up $140 billion-worth of deals. In 2004, the $150 billion mark had already been passed by the second week in December and it looked as if the year would end with a tally of something like $160 billion.

Driving this were issuers taking advantage of a combination of low treasury yields and a spread differential between investment grade and high yield at its tightest for 12 months. According to Merrill Lynch's US high-yield master index, high-yield spreads are the tightest they have been since 1998.

Yet despite this, in a year when investment-grade supply was 25% down, there was unprecedented demand from investors for high-yield issues in December. Buyers were lapping up every new deal that came in sight and fighting over allocations.

Hedge funds, insurance companies and pension funds are all allocating far more to the market than ever before in an effort to prop up disappointing investment results elsewhere.

"Given the size of this market, there's been a huge impact from the increased allocations from pension funds to the asset class," says Robert Hedlund, managing director and head of high-yield capital markets at Lehman Brothers.

Smart moves or a herd instinct?

Is this astute investment practice or are institutions indiscriminately buying because everyone else is? Admittedly, last year the high-yield market delivered an annualized return of more than 10%, which is much better than the performance of investment-grade paper, although much less than 2003's 28% return.

Some analysts think that investors are playing with fire. They question the wisdom of buying high-yield assets now in the mature phase of the credit upswing after an already substantial rally.

In an end-of-year report produced by CreditSights, the research firm's head of credit strategy, Louise Purtle, argued that "the speculative-grade universe has seen a late-in-the-year rally that has taken spreads to levels that are, to say the least, extremely optimistic."

Purtle thinks that the fundamental pressures are particularly worrying. "We remain concerned that the credit quality upswing is waning," she says. "The idea that the cyclical forces could shift more quickly than the market is expecting gives more reason for concern when one considers the idea that current market dynamics are encouraging issuers to embrace lower levels of credit quality."

The US high-yield market has become much more willing to accept lower-quality issuers and a broader range of sectors than ever before. Although media, telecoms, energy companies and deals involving financial sponsors account for the biggest proportion of the market, last year it was open to every sector from drugstores to house builders.

And the credit quality of high-yield issuers could be set to deteriorate even further. Moody's reported that the global speculative-grade default rate was 2.4% at the end of November 2004 and forecasts an increase in 2005 as a result of "changes in credit quality that are already taking shape, including an increase in low-quality speculative-grade issuance, a flattening yield curve and a relatively less favourable financing and macroeconomic environment."

Some investors are worried about market dynamics that make so-called drive-by bonds increasingly common – deals done for high-yield issuers that are announced and priced within a matter of hours.

"It's OK when investors have done a lot of credit work on the company before. But there is so much demand out there, it is possible for some investors to get carried away and buy into something that they really don't understand," says Fatima Luis, head of retail credit at F&C Asset Management.

Quality goes with speed

Lehman's Hedlund says that in his experience only well-known issuers are able to do these rapid turnround deals. "When we did a $600 million high-yield bond for Chesapeake Energy, which has over $3 billion dollars of high-yield outstanding, it was announced in the morning and priced in the afternoon," he says. But he points out that the deals Lehman was working on when Euromoney spoke to him, for first-time issuers – Californian oil company Venoco, propane distributor Inergy and the LBO of Cooper Standard – were all given full roadshows.

However, terms are getting more and more aggressive. "There are many more deals being done at holding company level and dividend deals [where the money goes to an equity sponsor] and on others the covenants are getting looser," says Stephen Peacher, managing director and CIO at Putnam Investments. But he adds that a lot of these sorts of new-issue deals have to be done for them to affect the performance of the wider market. "It certainly won't be a problem in 2005," he says.