Consensus is fairly bullish on the high-yield market for 2015 despite recent volatility. In fact, many market players believe that the volatility has limited frothiness in what they see as attractive valuations to enter the New Year. They say that the end of historically loose monetary policy has already been priced into the market and that the market is underpinned by steady economic growth, sound corporate performance, and ongoing investor demand for yield.
There are possible disruptions, such as the possibility that the Fed’s plan is derailed with unexpected data and that the six-month bear market in oil will get worse. Moreover, bankers relay ongoing concerns about the regulatory environment put in place nearly two years ago, and how the tighter restrictions may reduce deal making.
As for interest rates, most prognosticators were humbled last year when the U.S. Treasury bond market sell-off failed to materialize. But once again, the consensus belief is that rates will rise, with the FOMC widely expected to start raising rates in mid-2015. In LCD’s informal annual survey, the yield on the 10-year note was forecast at mid-2% to just under 3%, versus about 2.3% at present. Goldman Sachs stands out as more bearish on bonds, with the 10-year reaching 3% by the end of next year.
On the eventuality of rising rates, “as long as it’s semi-orderly, the bond market can adjust,” said John Gregory, head of high-yield syndicate at Wells Fargo Securities.
Current forecasts are for similar or higher new-issue volume in the year to come. Prominent bank forecasts for U.S. high-yield issuance in 2015 range from $260-340 billion. This compares to a pro forma $315 billion for 2014, which is in line with last year’s $321 billion.
Among the forecasts are a few outliers, such as Wells Fargo's call for a 25% contraction of issuance as energy issuers pull back and refinancing slows, and an increase by 8% out of UBS, but the average forecast is on par with this year’s pro forma domestic and Yankee speculative-grade corporate supply.
Among the lot, Barclays is estimating a rangebound $310-330 billion, while Citi targets a small decrease to $300 billion. Wells Fargo estimates $250 billion, and Morgan Stanley’s prediction is $339 billion.
Similarly, this year’s roughly 1.84% return as of Dec. 10 (which follows a 7% return in 2013 and a 16% return in 2012) is below the consensus forecast for the year ahead. Indeed, prominent bank forecasts range modestly from low-to-mid-single digits, with UBS, for one, pegging 3.9%, Citi laying out 4.5%, and both Credit Suisse and Barclays predicting roughly 5%. Outliers include Bank of America at 2.6% and Morgan Stanley at 6.48%.
“Heightened volatility will create the biggest challenges and opportunities in 2015,” offered Barclays strategists in the annual outlook.
Use of proceeds
Arrangers and dealmakers forecast a slight to moderate decline in refinancings. And they once again point to M&A as a large portion of the 2015 primary high-yield market.
“[Merger and acquisition] financing is favorable. The first half of 2014 was driven by refinancing. The second half turned to M&A financing, and that’s going to continue into 2015,” said a sellside source.
Indeed, first half issuance was 55% refinancing-related, while 27% of supply was M&A-themed. The respective percentages flipped to just 38% and 43% in the second half, according to LCD. Looking ahead, the shadow backlog has certainly been whittled significantly in recent months, but remains M&A-heavy at around $12 billion.
There are a few buyout-related names on the shadow, but don’t expect a balloon there, given the bull market in equity. The current environment presents a better opportunity for initial public offerings because multiples and margins are at the peak cycle, according to sources. The same dynamic was in place this past year, and LBO bond deals accounted for just $12 billion, or just 4%, of supply, according to LCD.
Instead, the current environment is where we'd expect to see "decent flow of sponsor-to-sponsor transactions, especially given the challenges around take privates," outlined Jeff Rowbottom, head of KKR Capital Markets for the Americas.
"A lot of the refinancing work has been done for the portfolio, but KKR and other sponsors will remain pro-active in pushing out maturities if rates remain low. I believe that there will be dividend deals for strong performing sponsor-owned companies," added Rowbottom.
Still, reaching even the mid-range of volume forecasts would mean steady business month to month and a considerable amount of net new issuance. Bankers indicate there may be less incentive for issuers to refinance before maturity if yields move higher than the average coupon, and bond-for-bond refinancings may decline notably in that case. But that should be offset by the expected pick-up in M&A and possibly more bond-for-loan refinancings as regulation pushes issuers in that direction.
One obvious speed bump is the energy sector, which accounted for roughly 20% of supply this year. Certainly there are deals to be done, but cutting that figure in half for 2015 would result in a pro forma 10% contraction to new issuance.
“Energy [issuance] will be down significantly in 2015. Credits may seek alternative financing,” instead of the regular-way high-yield syndication process, explained Wells Fargo’s Gregory.
KKR's Rowbottom said: "It will be interesting to see some of the rescue financings emerge in the energy space, whether they are private mezzanine, loans, bonds, or exchanges. Some credits may have enough runway to wait while hoping for a rebound in commodity prices, but others will have more pressure to get out in front of near-term liquidity concerns.”
An example is this year’s Preferred Proppants rescue. Jefferies and KKR Capital Market arranged a $350 million covenant-lite loan for the fracking-materials concern, with proceeds used to refinance the entire capital structure as KKR took a minority stake in the business via a combined debt and equity commitment topping $680 million.
Many energy deals that do hit the regular-way high-yield market could come as secured, particularly 2nd-lien, instead of previously unsecured, and/or in the form of rescue financings for better companies, which bankers say will be constructive. Moreover, fallen-angel activity could grow the high-yield energy sector significantly over the next several years. Some large issuers on the cusp include Transocean, Superior Energy Services, Weatherford International, and Rowan Companies.
Coupons certainly are likely to be more enticing amid rising rates, and strong demand, particularly for large, liquid issuers, could further result in issuer-friendly terms and looser debt covenants. More issuance may continue to stream out of Europe in the form of U.S. dollar Yankee bonds. This year that segment has totaled roughly $45 billion, for 15% of dollar-denominated supply, according to LCD.
Meanwhile, bankers say one area that may struggle is the smaller, less-liquid credits, as investor concern over liquidity intensifies in a rising-rate environment.
“One of the big themes of next year is the importance of liquidity. We hear from investors all the time that there isn’t enough liquidity on dealer desks, therefore smaller deal thresholds are getting higher and higher. Investors are concerned about the $250 million or $300 million deal for a middle-market company. There is a premium around big, liquid, repeat issuers, and it becomes more important with the Fed moving rates,” explained Marc Warm, head of U.S. Capital Markets at Credit Suisse.
Syndicate bankers are likely to remain creative with structures, though it’s not clear where the next innovations may arise. After the PIK-toggle invention during the 2005-2008 period, this current cycle will be characterized by an development of the shorter call schedule.
“If the market remains choppy, you are not going to see innovations, but keep an eye on covenants,” said Wells Fargo’s Gregory.
Short call structures offset by higher-than-usual first call premiums – a feature virtually unheard of before four years ago – have become a new standard, particularly the eight-year (non-call three) arrangement, with a first call premium at par plus 75% coupon. Roughly three quarters of eight-year tenors came that way in 2014, and it represented about a quarter of all high-yield supply.
Take note that of the sporadic issuance in the seven-year series this year, premiums have been equally split between par plus 75% coupon and the more aggressive, issuer-friendly par plus 50% coupon. And the five-year (non-call two) series at the issuer-friendly par plus 50% coupon has peppered the landscape, with seven deals arranged that way in recent months, according to LCD.
In sum, arrangers were able to bake in the short call (regardless of first call premium) into nearly 40% of annual supply, according to an LCD tally. That’s up from 28% last year and 20% during 2012, with just hints of it before that. (The first LCD has on record is Aeroflex in mid-2008.)
Meanwhile, FRN issuance may pick up in an increasing-rate environment, with bankers noting there will be some ability to issue FRN bonds as a replacement for bank debt, particularly amid the regulatory climate. Moreover, innovation may target the capital structure, not the individual deal structure and terms.
“You will certainly see some capital structures authored to try and pass regulatory muster,” said Richard Zogheb, co-head of capital markets origination for the Americas at Citi.
Wildcards are always in play, and despite a few wildcards this year – rates didn’t rise and oil prices plunged – last year’s predictions were right on target. The 2013 LCD survey for 2014 performance was for returns in the low single digits, and that, in fact, has turned out to be the case thus far. (Of course, without second-half volatility, those estimates would have undershot, what with year-to-date returns flirting with 6% at the end of the summer.)
QE is over and the “taper” was absorbed, but what could derail their well-broadcast intention for rate hikes starting in mid-2015? The recent jobs data and recent economic indicators continue to support that schedule, but there’s been talk rattling the market this month that the FOMC might remove the “considerable time” language from its statement about maintaining low rates.
OCC and the Fed
A more widespread concern is government regulation put in place early last year over sustainable capital structure, risk retention, and lending standards. At issue is the ambiguity under the guidelines and how the arrangement of deals could be interpreted differently. There is no line in the sand.
“A big question is the regulatory environment. Leverage would certainly be affected, and the question is whether [restrictions on leverage] will trickle down to deal activity,” according to one banking partner.
“Depending on valuations, and how far you are stretching, it might not start feeling that great.”
Market participants in the trenches, of course, complain that the marketplace is a better judge. Moreover, bankers worry that new competitors who are beyond the scope of the rules will emerge, such as second-tier banks and hedge funds, and that could draw further restrictions.
The third wildcard is the commodities market. Low oil, coal, and iron ore has put pressure on the high-yield market in spots, and it’s become an early prospect for the default cycle eventually turning.
“With falling prices come falling revenues for the oil exploration and refining companies and the distributors, and this has quickly translated into stressed market conditions for issuers in this sector, as well as a sell-off of their bonds in the U.S.,” according to Diane Vazza, head of S&P Global Fixed Income Research (S&P GFIR). “Futures prices for the end of 2015 are only $76.29 – up 8% from their current levels – with the longer-term outlook still well below the levels seen before the recent drop in the second half of this year,” added Vazza in a recent research note.
Certainly the E&P credits out there with high leverage are smartly hedged, so 2015 defaults are unlikely, but the landscape is littered with huge decliners.
Investors and traders meanwhile indicate that there will be plenty of opportunities, but are quick to stress the need for careful scrutiny and selectivity. “Everything is going to sell down, go through, and you’ll be able to buy things,” suggested one trading desk source.
“Energy represents 17% of the market, but not all energy is created equal. There are a lot of nuances to the sector. We believe that certain natural gas companies have a more favorable fundamental outlook over the next several years, but they are trading lower in general with many of the oil companies. We also believe certain pipeline and oil refinery companies offer an opportunity, “ said Mike Kirkpatrick, senior portfolio manager at Ridgeworth Seix High Yield Fund and Ridgeworth High Income Fund.
Whether shale drillers or services providers accelerate defaults into next year is an unknown, but the Caesars Entertainment restructuring in the obvious start to the year. Certainly it’s had a long lead time to market – negotiations have been underway at various levels in the capital structure for months – and many signs point to a bankruptcy filing after the 30-day graced expires on skipped Dec. 15 coupons (no such decision has been made as of Dec. 10).
Fitch Ratings' estimates the “impending” Caesars default would add 90 bps and push the trailing 12-month U.S. high-yield default rate to 3.2%. Likewise, a pro forma default reading on the S&P/LSTA Leveraged Loan Index rises 102 bps, to 4.35%, according to LCD.
Despite two defaults in November, S&P’s trailing-12-month U.S. corporate default rate was unchanged, at 1.6%. S&P expects to see the rate to increase to 2.4% by September 2015, according to GFIR.
As for LCD’s informal survey, Barclays outlined a range of 2.25-2.75%, while Credit Suisse targets a wider range of 1-3%. Meanwhile, UBS is at 2.4% and Citi calls it at 2.7%.
In sum, steady issuance and middling performance is in the cards for high-yield in 2015. Among the many prognostications on Wall Street, Barclays strategists calls it “attractive at the core” with “challenges and opportunities.” Morgan Stanley describes the coming year as a “seventh inning stretch” on a lengthy bull-market run, Wells Fargo is calling for “a return to fundamentals," but Citi flags a “potentially difficult” path ahead.
Additional reporting and analysis by Joy Ferguson
Check out www.highyieldbond.com for market news, analysis, and data.