Midcap issuers find favor in high-yield

Fri Jun 13, 2014 12:55pm EDT

NEW YORK, June 13 (IFR) - Small to midcap companies are finding favor with high-yield bond investors, who are pouring money into a sector offering very attractive double-digit returns.

Although once a niche space, the small to midcap segment now has some US$750bn of outstanding bonds, larger than the overall US high-yield market was in 2006, Bank of America data show.

And issuers in the sector offer premiums on their bonds to compensate for the deals being smaller and less liquid - as high as 500bp in some cases, market participants say.

That has only added to the appeal in the current low-rate environment, and investors - especially those struggling to get decent allocation on large liquid deals - are piling in.

"There has been a pick-up in the hunt for yield in the less liquid parts of the market," Barclays credit strategist Eric Gross told a high-yield bond conference in New York on Thursday.

"We have heard many investor types looking at less liquid securities in order to pick up a liquidity premium, and it's still pretty substantial," Gross said.

"There are juicy avenues by going lower in quality, but by also doing more credit work."

For example Millstreet Capital Management, which specializes in the small to midcap sector, saw a net return of 15.36% in the 12-months through the end of Q1 2014, according to data seen by IFR.

The Citi high-yield index returned 7.38% over the same period.

"We are finding more and more names and the pool is getting deeper," said Millstreet's Brian Connolly, who co-founded the Boston-based company in 2010.

"Yet there are not a lot of firms designed to exploit it."

WORK TO DO

One issue is that the sector requires a bit more work than others.

Millstreet said it needs to find an average 12-15 investment opportunities per year since 25-35% of the portfolio gets called, receives an early tender or gets acquired each year.

And Connolly told IFR the company, which buys around three-quarters of its deals in the secondary market, prefers credits supported by underlying assets that have high replacement costs - such as refineries, manufacturing facilities and mines - as an extra protection.

But the rewards for the work are there to be had.

The yield-to-worst on the Barclays US high-yield index hit a record low of 4.91% this week, which highlighted the contrast with the robust coupons on offer in the small to midcap space.

Among recent offerings, for example, unrated security firm Interface Master Holdings came to market with a US$115m payment in kind deal offering a 12.5%/14.5% cash/PIK coupon.

And commodity firm Lansing Trade Group's new US$175m unsecured issue came with a 9.25% handle.

Firms helping guide investors through the small to midcap space include Seaport Global and Imperial Capital.

Matthew Gourlay, managing director and co-head of capital markets at Seaport Global, said there was a huge middle-market desperate for paper.

He told IFR that larger mutual funds will traditionally only look at deals at least US$250m in size, which leaves the small to midcap trades out of the picture.

"They want US$50m or US$100m per name and cannot buy that kind of size in a US$125m-sized deal," said Gourlay.

Not only do smaller buy-side have more to go around, then, but they also have more sway over price, structure and covenants - something difficult to achieve even on risky Triple C trades from large issuers.

The Interface deal, for example, was upsized from the original US$100m - but only after investors demanded changes including an agreement that around US$35m from the proceeds would be placed into an escrow account to cover the coupon - US$14.73m a year - for the first 2.5 years.

On the Lansing trade, the maturity was cut from seven to five years - a shorter tenor that investors like.

More established issuers - some of whom are just as risky - meanwhile see much less pushback from the buy-side.

Ardagh's recent PIK priced tighter than expected even though some investors described it as one of the most aggressive bond deals of the year. Ardagh priced the US$710m dollar tranche at 99.00 with a 8.625% coupon. (Reporting By Mariana Santibanez; Editing by Natalie Harrison and Marc Carnegie)

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