Thursday, April 23, 2009

The Collapse Of The High Yield Market, And Why Highly Leveraged Companies Are In Run Off Mode

While the vicious love quadrangle (no pun intended Mr. Rattner) of Bernanke, Geithner, Lewis and Vikram pound the table on just how well lubricated the credit markets have become, the truth is that aside from ultra high quality Investment Grade names and TLPG-backed financial issuance, the credit market is for all practical purposes still in critical condition and about to be carted off to the morgue. The fact is that YTD issuance in the riskier HY and loan markets (see chart below) stands at a meager $22 billion - the lowest level in recent history. And drilling down with the HY issues specifically, the highest rated (BB) issues as a percentage of all issuance stands at 65% YTD: the second highest on record since the 1991 credit cycle bottom.

What is more troubling is that new issuance volume is not supply constrained: 81% of HY new issue proceeds is to refi existing debt, mostly near-maturing and cheaper loans. Normally refis stand at around 50% from a Use Of Proceeds perspective. As there is $80 billion in 2009 scheduled maturities, assuming the YTD issuance trend persists into the balance of the year, all else being equal, any new money will go dollar for dollar to match upcoming maturities. The refi rush is not limited to HY - of the other industrial BBB-rated deals done last month, all 8 listed refinancing as a use of proceeds (as well as the generic general corporate purposes).

While credit markets are still marginally open to only the highest quality and least risky corporates, it seems that virtually everyone who still has capital markets access is only focusing on balance sheet clean up. The other two major needs for new capital: M&A activity and CapEx are virtually at a standstill. This implies that the economic downturn is likely to get even worse as capital is drastically redirected not into investment opportunities and economic growth but merely band aiding against potential restructurings. This last point is further confirmed by the Fed senior loan officer survey, which indicates that over 60% of banks saw a drop in bank credit demand. So much for the Treasury's cheap credit being used to flow back into the economy: the major beneficiaries from any loosening in credit conditions seem to be banks themselves who manage to offload their existing loan exposure in risky names to new investors. This is a phenomenon we have seen recently with none other than the REIT space, where instead of HY bonds, outright equity has been issued to repay banks' credit facilities.

Two other items to be pointed out are that if the recent rally collapses and credit capital markets shut down (not to mention REIT equity refi opportunities), then the massive upcoming 2009 maturities have no chance of being addressed and the default wave will likely end up even worse than Moody's and S&P's estimates of 2009 full year defaults of over 20%. A logical follow through question is with all the upcoming bankruptcies and the resulting mass lay offs, how can any pundits (let alone economists) say we will soon see an abatement in unemployment trends? If 20% of all HY companies indeed file for bankruptcy, the additional numbers of unemployed (by some estimates around 3 million upcoming pink slips) will represent another huge shock to the U.S. economic system. And this number excludes the newly unemployed from the upcoming fallout of a GM bankruptcy.

The other item to point out is that the limited demand for new issues as HY investors are not stupid and would rather not funnel their money into banks' loan repayment, but would rather see some economic use of their capital, even if the rate is exorbitant: a 15% interest rate bond bought at par that goes to 40 in one year is still a loss of 45%. This has manifested itself in higher secondary market prices for older vintage deals, the result being an outperformance of older vintage HY deals. As the technical considerations eventually dissipate it is likely that we will see a substantial sell off of the lower rated HY bonds, to parallel the upcoming sell off in the "crap" stocks that have driven the last month's equity rally.

hat tip to BofA for primary data. Sphere: Related Content
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