US debt markets: Record high-yield issuance drives US debt boom

APPARENTLY HE’S NEVER had it so good. And that’s starting to make some people nervous. Henry Kravis, co-founder of Kohlberg, Kravis and Roberts, recently pointed the way for the private equity sector in his comment to Bloomberg in March that the financing achieved on KKR’s recent acquisition of San Francisco-based Del Monte Foods “was the most attractive financing that we have ever done”.

The high-yield market in the US is booming. Volumes are flying. Spreads are tight, and dealers expect them to get tighter still.

After breaking issuance records in 2010, high-yield bonds are on pace for another record year, already reaching $133 billion by mid-May, compared with $302 billion for 2010. The $107 billion printed in the first three months of the year set a new quarterly record. According to Peter Acciavatti, managing director and head of JPMorgan’s high-yield and leveraged-loan credit strategy team, US investor allocations to high yield continue to grow, with domestic retail mutual funds and foreign institutional investors adding to already robust demand. “We are on pace to double last year’s inflow into US high-yield mutual funds. Inflows total $10.4 billion so far this year, compared with $12.2 billion for all of 2010,” he says. Overseas investors too are looking at ways of participating in dollar high-yield markets, he adds. “A high proportion of the new mandates are coming from overseas buyers. Specifically, European and Asian institutions are allocating more capital to dollar high yield as a percentage of their fixed-income assets,” he says.

The flood of money into high-yield paper has driven issuance levels close to those in the US investment-grade markets, according to analysts at Bank of America Merrill Lynch, who contrast the $50 billion of high-yield bond volume ($75 billion if leveraged loans are included) in March with the $65 billion a month issued in US investment-grade markets over the past year.

Now some specialist investors are itching to call the top of the market. They say that persistent monetary accommodation by the Federal Reserve is undermining credit standards in leveraged finance, a trend that will likely be accelerated as deal sponsors demand the same terms as KKR. Brad Beman, chief investment officer and director of high yield at Aegon USA Investment Management, says that at the very least he expects more triple-C paper to emerge. “With the market so strong, we are seeing more aggressive financings, including increased leveraged buyout activity and dividend recaps from privately held high-yield companies. The quality in the first quarter of 2011 has continued to deteriorate, with triple-Cs making up a larger portion of the new-issue calendar,” he says. He adds that he has taken profits on weaker names and replaced them with core holdings that still offer attractive spreads compared with fixed-income alternatives.

Moreover, with each record tight print, investors see value draining from the market. Although the positive fundamental credit outlook, with the trailing 12-month corporate loan default rate at 1.1%, renders talk about underweighting high yield premature, some of the largest bond investors are choosing not to increase their positions, while others are reducing participation. Rick Rieder, head of fundamental fixed income at BlackRock, says that high-yield valuations might have already overshot. “We have significant weightings to high yield, but it seems that valuations for the asset class are becoming stretched,” he says. “New-issue supply is either coming from issuers that we don’t find as attractive, or with covenants that are looser. With the end of [monetary policy] QE2 looming, we haven’t increased our exposure. Tactically we are looking to moderately reduce some of our holdings in the weaker sectors of the asset class but within an overweight paradigm.”

It’s brave to call the top of the market. US high-yield investments measured by the JPMorgan Domestic HY index generated a total return of 6.1% so far this year, with a strong contribution coming from triple-C bonds, which returned 7.9%. The obvious appeal of this risk/reward trade-off in the present yield environment is encouraging more lower-rated credits to market. For example, issuers rated triple C by at least one of Moody’s and S&P accounted for 21% of all issuance in 2011, compared with 18% in 2010, according to JPMorgan. Most participants expect this proportion to rise as turnover moves in line with increased M&A and LBO activity.

High yield is the standout story of the US debt markets so far, which could easily have faced a bloodbath rather than a bonanza as the parlous state of that nation’s fiscal health dominated the policy agenda. As it turned out, however, treasury investors barely flinched as Standard & Poor’s revised the outlook on the federal government’s sacrosanct triple-A sovereign rating to negative and digested the topping-out of the federal government debt ceiling at $14.3 trillion on May 16 with little turbulence.

“The S&P downgrade didn’t tell investors anything they didn’t already know. What is dominating investor behaviour is US investors’ reach for yield” Jeff Rosenberg, BAML Global Research

“The S&P downgrade didn’t tell investors anything they didn’t already know. There was very little that was new in the release, hence very little price impact on rates or credit. What is dominating investor behaviour is not the long-run fundamental fiscal picture of the US government, or the fundamentals of corporate earnings. The overwhelming driver is US investors’ reach for yield,” says Jeff Rosenberg, head of global credit strategy at BAML Global Research. As QE2 moved towards its conclusion in June, treasury yields continued to fall from already rock-bottom levels. Between May 9 and 13, two weeks ahead of the deadline, some $34.7 billion of Fed purchases across the treasury curve accounted for more than half of the week’s $72 billion auction. Ten-year yields, for example, have fallen by 35 basis points over the past 12 months, implying real 10-year rates at 0.82%. The 30bp rally in the five-year over the same period, meanwhile, now implies a real interest rate of minus 1.72%. Against the inexorable weight of monetary easing and negative total returns from treasuries in the first quarter, it’s been full steam ahead for the risk-on trade in US credit.

Loans lift US fees

Seemingly every part of the US debt spectrum is in acceleration mode. Although the loans market missed out on the first phase of the US leveraged finance bonanza in 2010, it definitely caught up. First-quarter volume climbed to $137 billion, according to S&P Leveraged Commentary & Data (LCD) a level of issuance not seen since the great credit expansion of 2003–07. Loan issuance in the first quarter of 2011 was the busiest since the second quarter of 2007 and 216% up on the same period in 2010. Institutional loans, or those offered to the market rather than retained by banks, accounted for $103.7 billion, up 103% from the fourth quarter and 237% from the first quarter of 2010. However, because they aggregate flows driven by the three Rs of leveraged lending – repricing, refinancing and recapitalization – along with leveraged buyout, M&A and dividend recap motivated issuance, the headline numbers tend to overstate the role played by new money. According to LCD, repricing, refis and recaps accounted for 76% of the proceeds of all loan issuance in the first quarter. M&A, for example, generated $30.4 billion of new loan issuance, with $19.9 billion offered to investors. Notwithstanding the smaller notional amounts, M&A-related loan issuance in the first quarter was more than double the level achieved in the same period in 2010.

Unsurprisingly, investment banking fees from lending surged 40% in the first quarter to $2.8 billion, according to the Thomson Reuters Global Investment Banking Review, making loans the top growth business line for global banks. Notably, the top-four earners in the loan market – BAML, JPMorgan, Credit Suisse and Barclays Capital – derived the bulk of their total loan earnings from lending to the Americas, according to the report.

Robert Polenberg, an analyst covering US loan markets at S&P LCD, says that issuers dominated most of the first quarter, until geopolitical unrest and the Japanese earthquake allowed investors to reassert themselves in mid-March. After a bout of modest spread widening led some issuers to pull some of the more ambitious repricings, loans have resumed their tightening trend, with most participants seeing spread widening as a buying opportunity. “Much of the growth has been to the benefit of issuers who have been using new demand to push out maturities,” Polenberg says. “Already the 2013 maturity wall is down 67% over the past two years, and the market is moving on to the 2014 issues. This is great for the companies because they are able to do it at a lower cost because spreads are so much lower than they were in 2008–10.”

US retail investors played a decisive role in driving asset allocation towards loan markets in the first quarter. Data provided by Lipper FMI show that US investors injected $15.5 billion into loan mutual funds in the first quarter, pushing that sector’s share of the primary market to 30%. Meanwhile, insurance companies and other financial institutions appear to be waiting for further information on the direction of interest rates. “Public mutual funds have really taken the day, contributing a lot of new capital to the loan market,” Polenberg says. “Institutional investors, although capable of coming in for big allocations, haven’t yet committed significant capital. This still appears likely, however, as the motivation to move into loans will be stronger when rates appear to be climbing.”

“Every time high-yield bonds are in the 7% area, the concern is that there is not enough coupon to compensate for the long-term risk” Mark Okada, Highland Capital Management

Although the majority of institutional investors might feel that the most attractive way to play US credit is through the high-yield bond market, dedicated loan investors suggest that the time has already come to move into loans. Mark Okada, co-founder and chief investment officer at Highland Capital Management, argues that loans should compare favourably with high yield for investor attention because it is hard to see rates going much lower from here. “The high-yield market has had great returns, but 75% of the total return is due to lower base interest rates, and 25% comes from tightening spreads,” he claims.

Loans have performed almost to the level of high-yield bonds, with the Credit Suisse Leveraged loan index returning 2.65% in the first quarter versus the 3.77% returned by the Credit Suisse High yield index, but should outperform in a rising rate environment because they pay coupons on a floating-rate basis. Furthermore, a senior-secured position in the capital structure affords investors greater credit protection should things turn sour.

It also doesn’t hurt that loans as an asset class remain cheap, around 500bp wide to the historical average, while high yield as an asset class is now trading at historically tight spreads, commanding a substantial premium to par. “Every time high-yield bonds are in the 7% area, the concern is that there is not enough coupon to compensate for the long-term risk. Senior-secured bank debt is an appropriate risk/reward proposition at this point of the cycle,” Okada says.

Top of the fourth

As is their wont, US participants invoke baseball analogies when estimating the current position in the credit cycle. In a game of nine innings, few investors are prepared to wager that the cycle has reached even the halfway point yet. “We continue to see improving fundamentals reflected in earnings, leverage and liquidity, lower default rates and a higher ratings upgrade-to-downgrade ratio. We are still in the expansionary stage of the credit cycle, in baseball terms the fourth or fifth inning,” says Aegon’s Beman.

Is corporate America using easy access to credit to releverage itself? According to BAML high-yield analysts, net leverage for US high-yield issuers fell to 3.3 times the last 12 months’ (LTM) ebitda from 3.4 times in the previous quarter, close to its historical lows of 3.2 times recorded in 2005. Earnings in general improved for the fifth consecutive quarter on a year-on-year basis, with ebitda up by 15% from a year previously. Meanwhile, total debt outstanding on high-yield issuer balance sheets increased at 6% year on year, well below its cycle highs of 15% for five consecutive quarters starting in 2007.

Although specific issuers have used proceeds to finance leveraged buyouts or to fund dividend payments this year, they constitute a relatively small fraction of overall market activity, less than 10% in the case of dividend recaps. “These transactions represent less than a dime of every dollar raised in the market,” BAML says. “As aggressive as these deals sound to the ear of a credit investor, their impact on overall leverage remains muted at the time when earnings are growing faster than overall debt stock.”

By definition, leveraged finance markets exist to make credit available to borrowers with a relatively high likelihood of default and the extraordinary liquidity conditions within US capital markets have ensured a historically exceptional level of supply. Despite the improving fundamentals, however, the re-emergence of some pre-crisis habits points to potential trouble spots. As indicated by investors, the level of triple-C and unrated assets is growing in both bond and loan markets, climbing from a low of 20% in 2009 to nearly 30% so far this year. Although this is much less than the peak levels of 2007, when triple-C and unrated assets accounted for more than half of all leveraged finance deals, credit quality is clearly trending down.

Increased issuance of covenant lite-loans, which absolve issuers of the requirement to report and maintain loan-to-value, leverage and ebitda ratios, has also sparked debate. LCD data shows that cov-lite loans re-emerged as a mainstream product in the first quarter, accounting for $24.3 billion (24%) of the institutional market. Critics of the low-maintenance lending format say that the absence of performance metrics makes it possible for issuers to increase leverage without giving lenders the ability to intervene and take remedial steps. Furthermore, the lack of lender intervention rights means that borrower could continue to burn through cash, and push potential recoveries lower in the event of default. Both prospects hurt banks seeking to value loan portfolios during the credit crisis. However, cov-lite loans can afford high-quality borrowers the flexibility to manage balance sheets during challenging economic conditions, like those currently prevailing, without risking technical default. Furthermore, investors say that cov-lite loans suffer fewer defaults than covenant-heavy products and tend to perform better on a total-return basis.

“As dedicated loan investors, we are willing to give up covenants for higher-quality issuers. Performance data show that defaults are lower for covenant-lite loans, and returns are higher, often because the underlying issuer is larger and higher quality. I am not worried about growth in cov-lite issuance,” says Highland’s Okada.

Replacing QE2

If persistently accommodative monetary and fiscal policy have driven the remarkable rebirth of US credit markets, what happens when Ben Bernanke pulls the plug in June? Analysts say recent economic history shows that when the Fed makes a coordinated and well-flagged exit from a high-quality bond market, the private sector steps in to mop up excess supply. Guy Le Bas, chief fixed-income strategist at Philadelphia-based broker dealer Janney Montgomery and Scott, says that even without the $700 billion of additional demand from QE2, the treasury market will continue to attract global investor demand. “As the evidence shows, when the Fed ceased its mortgage-backed securities purchase programme in 2010, private investors took over and demand was sufficient to maintain a stable spread between mortgages and treasuries. The deepest bond market in the world will find new investors. The end of QE2 alone is not going to cause a spike in rates,” he argues.

There is altogether less certainty about the federal government’s ability to wean itself off debt finance. While Treasury secretary Timothy Geithner has bought a few months’ breathing room by shuffling money between government agencies, the legislative and executive branches must overcome a bitter political divide to raise the debt ceiling while reducing overall government spending in the long term. BlackRock’s Rieder argues that anything that helps focus legislative attention on the need to deleverage the federal balance is welcome at this point. “Although the idea of a sovereign default in the US is inconceivable, it’s essential for the parties in government to come together to reduce the fiscal deficit. It’s going to be an interesting couple of months, and certainly there will be some volatility and push back along the way,” he says. With credit fundamentals continuing to improve, it seems that interest rate volatility for whatever reason remains the main risk to the credit market rally. The consensus view among credit investors that the US economy is in a period of slow growth, with high unemployment and relatively low inflation, means most are comfortable with the view that the Fed will leave short-term rates on hold, with 10-year rates range bound between 3% and 4%. “Very low Libor rates result in low all-in yields for bank loans, making high-yield bonds more attractive,” says Aegon’s Beman. “We do believe that in the longer term, as the Fed eventually begins to tighten monetary policy, the floating-rate nature of bank loans will represent a more compelling value proposition.”

Although the Fed remains relatively sanguine about rising energy and food prices, asserting that “subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period,” at the April 27 FOMC meeting, US investors have been rather more jittery. As last November’s exodus out of high-duration bond mutual funds into loan funds shows, loans are standing by to carry the baton for US credit markets should short-term rates come under more inflationary pressure.