US junk bond issuers expected to set record low coupons

Thu Jul 19, 2012 4:03pm EDT

NEW YORK, July 19 (IFR) - A desperate search for yield is expected to open a clear window of opportunity for companies carrying junk bond ratings to post record low coupons in coming weeks.

Nearly US$5 billion has flowed into high-yield mutual funds over the past five weeks but this resurgence of interest in high-yielding products has not been matched by supply of primary deals.

"Given the 10-year yield is below 1.5% and the threat of a third QE (quantitative easing) overhangs the market, investors are beginning to accept lower coupons again," said Michael Anderson, chief high-yield bond strategist at Citi.

"The speed at which this happened is surprising but the trend is understandable."

Demand for high-yield is not yet evident across the board with the higher quality segment of the high-yield market seeing the most interest.

This is because as crossover accounts move down the credit curve in search of yield, traditional high-yield investors are staying away from lower quality bonds.

According to a Barclays report last week, over the past two months, Double B-rated bonds returned more than 1.5%, easily outperforming the market, while Triple C-rated bonds produced almost no total return at all.

"High-yield investors have clearly expressed a more cautious view of the world by bidding up Double B-rated bonds at the expense of lower quality," said Barclays analysts.

"Approximately one-third of this relative performance is driven by the greater sensitivity of Double Bs to Treasuries, but even in excess return terms the trend holds, as investors have been increasingly reluctant to hold Triple C risk in the face of ongoing turbulence in Europe and disappointing macro data in the US," said the analysts.

RATE RISK

Higher quality paper may look attractive, but just a few months ago, overwhelming demand for Double B-rated names, and the resulting record low coupons, eventually led to their underperformance in late March when Treasury yields backed up. At that time, the 10-year Treasury moved out of its then four-month 1.8%-2.10% range to as high as 2.38%.

A host of Double B-rated deals that were brought at around the 5% range in February and early March quickly sold off as the market backed up.

Others trying to tap the market at those low rates received pushback or were forced to withdraw from the market altogether as investors demanded at least an extra 100bp. The new coupon floor was set at around 6% for those rated Double B and just below investment grade.

That floor is now likely to be broken again as the average yield-to-worst approaches 7% and Treasury yields move back below 1.50%.

Last Wednesday, the yield-to-worst moved in to 7.06%, according to the Barclays US high-yield index, its lowest level since May 11. This compares to 8.15% on June 5, the current high for this year.

The average yield has dipped below 7% just twice this year, in late February and in early May.

Meanwhile, the average yield-to-worst for Double Bs was quoted at 5.49% on Wednesday, the lowest level since early March.

Citi's Anderson said managers had plenty of cash to put to work, but there's still uncertainty about the economy, which is resulting in a bias towards higher-quality paper. But this is not without risks.

"Not only does it require taking on the usual credit risk, even if it's at the top of the high-yield spectrum, now you're overlaying more interest rate risk. If you get a reversal and a back up in longer rates, some of the higher quality bonds could suffer from the duration perspective," he said.

Already this week, well-known issuers rated Double B are seeing a very strong bid.

Smithfield Foods priced an upsized US$1 billion 10-year non-call five senior unsecured issue at 6.625% at a discount of 99.50 to yield 6.694%. The B1/BB rated notes traded up to 102.75.

Meanwhile, Hologic's US$1 billion B2/BB rated eight-year non-call three senior notes (upsized from US$750m) are trading 100bp tighter in the aftermarket after pricing at 6.25% at par.

Investors remain concerned about potential fallout from the yield compression.

"From a spread standpoint, the market is appropriately priced. But from a yield perspective, it feels like a bubble forming," said one high-yield investor.

"If Treasuries widen, high-yield will get blown out and anything that is higher quality will get thrown under the bus."

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