Outlook 2012: High-yield primary market could see $180-$250 billion of issuance in year ahead

By Paul A. Harris

Portland, Ore., Dec. 30 - Most forecasts for the year ahead call for issuance in the high-yield bond market that might ultimately come up short of the $255.3 billion seen in 2011.

In a note to its clients J.P. Morgan Securities forecast $225 billion.

Bank of America Merrill Lynch forecast $250 billion of global issuance.

Citigroup Global Markets is looking for $230 billion of U.S. issuance in 2012, according to a syndicate source there.

Strategists from Barclays Capital, in a note to clients, forecast $180 billion to $200 billion.

The low end of that range, $180 billion, represents the most conservative number heard. Most of the banks based in Europe seem to be conservative in their outlooks, a New York-based syndicate source explained, and added that the syndicate believes that 2012 issuance could actually go as high as $220 billion.

In a note to its clients, Morgan Stanley gave a base case issuance forecast of $250 billion.

Wells Fargo Securities, in a note to its clients, forecast issuance approaching $200 billion.

Speaking off the record, one senior debt capital markets banker forecast that 2012 issuance will come in flat to- or perhaps 10% higher than 2011 issuance.

The X factor is Europe, the banker said, citing the ongoing European financial crisis which was mentioned by most of the market sources surveyed in the waning days of 2011.

Up to $20 billion in January

The January primary market could be sizable but is unlikely to be massive, sellside sources say.

"We're looking for a $10 billion to $20 billion month, but not $30 billion," a syndicate banker said.

Heading into the new year, a trader professed visibility on at least $6 billion of January business.

At year-end there was visibility among other market sources on a substantial portion of that amount.

Physio-Control is expected to launch a $315 million offering of senior secured notes sometime during the first two weeks of the month, according to a high-yield portfolio manager.

Citigroup and RBC led the bridge syndication and will lead the bond deal.

Heading into the new year, the first massive deal on radar screens is Samson Investment Co.'s $2.25 billion of senior notes.

That deal via JPMorgan, Bank of America Merrill Lynch, Barclays Capital, BMO, Citigroup, Credit Suisse, Jefferies, Mizuho, RBC and Wells Fargo is expected in early January.

In addition, Datatel Inc. is expected to attempt to place $530 million of senior notes (Caa1/CCC+) in early January via JPMorgan, Bank of America Merrill Lynch, Barclays Capital, Citigroup and Credit Suisse.

The two faces of 2011

Looking back at 2011 junk bond issuance at year-end reveals a year with two very distinct halves.

The market saw $191.25 billion of issuance in 430 junk-rated, dollar-denominated tranches to the June 30 close, eclipsing the issuance seen in the first half of the record-setting previous year, which had seen $119.44 billion in 285 tranches.

However the primary market crawled through the second half of 2011, seeing just $64 billion in 117 tranches, vastly underperforming the 2010 second half's $172.51 billion in 371 deals.

Hence a year that sped to its halfway point in such robust fashion, on a pace to break the 2010 all-time yearly issuance record of $291.95 billion in 656 tranches, ended $37 billion short of the mark, at $255.3 billion in 547 tranches.

Various explanations were offered to explain the drastic slowdown seen in the second half of 2011.

Most of them shared one word in common: Europe.

Recapping the turbulence

Although 2011 was by no means a banner year for junk bonds, junk significantly outperformed stocks, according to a mutual fund manager who said that the Lipper high-yield index returned 2.03% for the year to Dec. 22, while the S&P 500 stock index stood at negative 4.27% at that point.

High-yield returns during early 2011 were robust, the source added, noting that junk was up 4% at the end of March and up 5.3% at the end of May.

At that point the air started to come out, said the buysider, adding that from May until the end of July the market was flat.

Dramatic depreciation took place on the heels of Standard & Poor's Aug. 5 announcement that it had downgraded the U.S. credit rating to one notch below AAA, the buysider recounted.

"At that point the market fell out of bed," the investor said, adding that high yield, which had returned 5.2% for the year to Aug. 1, was negative 0.1% by Aug. 12, a drop of more than 500 bps.

A 'windows' game

Year-end conversations with market players regarding memorable executions of 2011 often came with a "wing and a prayer" theme.

With market conditions furnishing all of the turbulence anyone could hope for, the dealers brought some of the year's big, committed financings into the market with a heightened sense of timing.

"This year the primary market was a 'windows' game," a syndicate banker remarked during the run-up to Christmas.

A senior debt capital markets banker at a different institution also used the term, "windows."

"This year we had rallies that lasted for weeks, rallies that lasted for days, and rallies that lasted for hours," the banker reflected.

"Some windows that were open at 8 a.m. were closed by 4."

Sealed Air - 'We got it done'

More than ever before, 2011 saw dealers with big, committed financings circling up the buyside by means of bridge loan syndications in which high-yield accounts participated in the bridges backing the bonds, market sources said.

The most frequently mentioned deal in this category was the Sept. 16 transaction featuring Sealed Air Corp.'s $1.5 billion two-part offering of senior notes (B1/BB) to help fund Sealed Air's acquisition of Diversey Holdings Inc. from the Johnson family and Clayton, Dubilier & Rice.

The deal included a $750 million tranche of eight-year notes, which priced at par to yield 8 1/8%, and a $750 million tranche of 10-year notes, which came at par to yield 8 3/8%.

Citigroup, Bank of America Merrill Lynch, Morgan Stanley and RBS were the bookrunners for the eight-year notes. Citigroup, Bank of America Merrill Lynch, BNP Paribas and Credit Agricole were the joint bookrunners for the 10-year notes.

Perhaps understandably, appreciations of the Sealed Air deal split along the line dividing the buyside and the sellside, with the buyside liking the deal because it came considerably cheaper than anticipated and traded dramatically higher, while the sellside liked it because it received a notable execution in a very choppy market.

"It came during a real downdraft," said a portfolio manager who added that "it was attractive and extremely cheap."

In late 2011 the Sealed Air bonds were trading around 109 bid, sources said.

Sellsiders reflected that the Sealed Air deal, coming during one of the crescendos of the European sovereign debt crisis, succeeded in actually reopening the high-yield primary market - if only for a while.

Among other notable 2011 executions that received multiple mentions was the Reynolds Group Issuer Entities' massive $2 billion two part deal, which doubled in size and which came in the heady days of late January via Credit Suisse.

It came at the approach of the debt ceiling deadline confrontation, which unfolded between the two major political parties in the U.S. government, and with the euro zone's financial circumstances beginning to unravel, a syndicate banker reflected.

Also the deal, which was related to the Reynolds acquisition of Graham Packaging, came on the heels of the company's $3 billion junk bond deal related to Reynolds' acquisition of Pactiv Corp., which was transacted less than three months earlier, the official recounted.

Meanwhile the year's biggest deal, HCA, Inc.'s $5 billion two-part drive-by, came in late July, just before the market began plunging in earnest.

That massively upsized deal, from a syndicate led by JPMorgan, was first announced at a size of $1 billion.

Playing the bridges

The Sealed Air deal exemplifies a trend that burgeoned during 2011: dealers aggressively syndicating bridge loans as a means of de-risking balance sheets.

It also provides one episode which encapsulates the market's turbulence.

One investor, who played both the bridge and the bonds, recounted that the Sealed Air bridge loan, which was syndicated in the late June-early July time frame, was capped at 10%, which at the time looked generous to this investor's firm because in a market that was still rallying it appeared that the Sealed Air bond deal could get done in the high-6% or low-7% range.

Hence there appeared to be plenty of cushion in the bridge.

Then came turbulence and the market backed up, causing the luster on that 10% bridge cap to tarnish and causing the investor to wonder whether the deal sponsors might ultimately demand a reckoning.

Eventually the bond deal materialized, however, with yields on the respective tranches coming at 8 1/8% and 8 3/8%.

And for sweating out the interval during which the bridge remained in place this investor received a better allocation of the bonds than would likely have been the case otherwise.

"We were already in the name and wanted more exposure," the investor said.

"Those bonds priced at par and immediately traded to 102¾ bid.

"Had I not been in the bridge I would have had to chase them in the secondary, at those higher prices."

Hence bridge participation increased this investor's profits by way of a more generous allocation of bonds at par.

Sources both in Europe and the United States anticipate that bridge syndications of this sort will continue apace in 2012, as the dealers will remain keener than ever to de-risk their balance sheets.

Higher quality eyed

Although the final deal to price in 2011, 99 Cents Only Stores Inc.'s $250 million issue of 11% senior notes due 2019 (Caa1/CCC+/), bore "triple-hook" credit ratings on both sides of the split, initially the 2012 primary market is likely to favor higher credit quality, said an asset manager whose portfolio includes both high-yield bonds and stocks.

"The U.S. economy will expand, which should make it a good year for bonds rated above triple C," this buysider said.

A manager, from a different fund, whose portfolio includes bonds and leveraged loans, more or less agreed with this assessment but warned that should the economy achieve some genuine traction those funds with limited exposure to triple-C bonds will underperform.

A syndicate banker also anticipates greater demand for higher credit quality, at least in the early part of 2012, although interest in high single-B bonds will likely build if the market gets momentum, the banker said.

Defaults should remain low

Heading into the final month of 2011, high-yield defaults remained at historical lows, according to market sources.

Moody's Investors Service's trailing-12-month global speculative-grade default rate fell to 1.8% from the previous month's 1.9%.

Standard & Poor's U.S. corporate speculative-grade corporate default rate rose to 2.06% from the previous month's 1.94%.

High-yield players tend to expect default rates to remain low in 2012.

"Our outlook is relatively benign," a senior syndicate banker said. "The economy is lousy but companies are doing just fine.

"There are always unforeseen issues, but right now there are no sectors that are in real dire straits."

Meanwhile a portfolio manager looks for 2012 defaults in the low single-digits - perhaps 2% to 3%.

A high-yield syndicate banker also targets a default rate in the 2% to 3% range but added that over the course of the year defaults will likely begin drifting toward their historic average, which is nearer to 5%.

Europe - The X factor

The ongoing financial crisis in the euro zone weighed on sentiment in the high-yield market, especially during the final quarter of 2011, sources admitted.

There was some consensus that it could continue to do so, especially during the first quarter of 2012.

Expectations for the euro zone among U.S. high-yield watchers tended to be gloomy.

"You wonder whether Europe can afford to get itself out of this mess, anymore" said an investment banker who spoke off the record and who added that ultimately it might require a global combination of forces - say the G20 acting in conjunction with the International Monetary Fund - to turn things around in the euro zone.

However while some market-watchers remain wary that a catastrophic event in the euro zone, on a par with the Lehman Brothers bankruptcy in 2008, could derail the U.S. high-yield market, others were seeing a separation in the fortunes of the European high yield and its counterpart in the United States - a separation that would favor the latter.

"Banks in Europe are going to want to raise dollars, and they are going to be pro-actively selling assets in order to do it," said a high-yield mutual fund manager based in the midwestern United States.

"The European banks are going to have to shrink their balance sheets. Otherwise they're going to have to raise equity, which could be a challenge."

U.S. asset managers, venture capital firms and hedge funds are already ramping up European operations in order to be prepared to take part in the anticipated liquidation in the most efficient and profitable manner possible, the source added.

Also European issuers that can are going to want to raise dollars, the fund manager forecast.

2012 European high yield

A London-based debt capital markets banker more or less agreed with that latter assertion.

Evidence should surface early in the new year, market sources say.

Poland's Polkomtel SA, which had a €900 million equivalent junk bond deal primed and ready in early December, only to push the transaction into 2012 due to ongoing turbulence, is expected to raise part of those proceeds in dollars.

The deal, which should be the first sizable transaction out of Europe in 2012, is expected to come in January.

Deutsche Bank and Credit Agricole are expected to lead.

Overall 2012 European high-yield issuance is apt to be flat to that of 2011, or perhaps lower, the London-based banker added.

"You're liable to see companies doing amend-to-extends to push out loans rather than issue new bonds," the source remarked.

Private equity volume in Europe will be low because selling a company in the present mess is disadvantageous from the seller's perspective.

And European high-yield investors will likely be even more focused on credit quality than their counterparts in the United States, the banker said.

Eyeing the Volcker Rule

Finally, a subject that arose in numerous conversations during the waning days of 2011 was the Volcker Rule, which is a section of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

It is intended to limit banks' ability to make speculative investments that do not benefit their customers.

The rule, which is scheduled to be implemented in July, remains under discussion, and at least one draft version has circulated, market sources say.

The Volcker Rule was a hot topic at the Bank of America Merrill Lynch Leveraged Finance Conference, which took place from Nov. 30 to Dec. 2, according to sources who were on hand.

Late in 2011 buyside and sellside sources asserted that some of the more extreme proposals, should they be enacted, would significantly restrict the trading activities of the dealers.

Apprehensions surrounding the bill may have already decreased the liquidity of the market, sources say, but add that the extent of the impact of those apprehensions is not easy to determine in light of de-risking related to the European financial crisis that was underway throughout the latter part of 2011.

Nevertheless, dealer inventories were vastly reduced by the end of 2011, relative to where those inventories were at mid-year, according to both buyside and sellside sources.

If indeed the Volcker Rule results in a significantly reduced amount of proprietary trading on the part of the dealers it will likely follow that there will be an increased liquidity premium for smaller issuers, said a New York-based debt capital markets banker.

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