The high-yield market turned decidedly unfavourable during April. Underwriters postponed some high-yield offerings that were designed to refinance bridge loans, citing market conditions. Pundits widely attributed the weakness to potential oversupply, based on the possibility (soon to become a reality) that both General Motors and Ford would join the speculative-grade universe through downgrading.
To high-yield market veterans, it was disturbingly reminiscent of the early stages of the Great Debacle of 1989–1990. Then, too, it became difficult to take out interim financing for leveraged buyouts (LBOs) with high-yield bond deals. In a further parallel to the present, observers cited fears of oversupply.
In that earlier period, conditions got quite ugly before the high-yield market came roaring back with a record total return in 1991. Some investment banks had gone beyond merely stating that they were highly confident that they could arrange permanent financing for LBOs on which they served as advisers. Instead, they contractually committed themselves to the proposition, putting their own capital on the line.
When outflows from high-yield mutual funds began to limit access to the new-issue market, the bankers grew increasingly desperate to finance their way out of their commitments. The only way to float a high-yield offering was by taking in other bonds on swap. Institutional investors exploited the situation by unloading their worst credits on the underwriters of the new deals.
Even as demand shrank, investment banks continued to pump out new issues. So high was the probability that the deals would sink in price after being freed from syndicate that dealers' trading desks found that they could short them with impunity. As one adverse market mechanism reinforced another, investors' returns plummeted.
Readers should not infer from parallels between 1989–1990 and 2005 that a second Great Debacle is imminent. Several structural changes suggest the high-yield market should have greater resilience than in the past. Today's investor base is more diverse, risk controls are tighter at investment banks and a more developed market for leveraged loans offers an alternative for takeout financing.
On the other hand, hedge funds are much bigger players in speculative-grade bonds than they were 15 years ago. They could create considerable disruption by heading for the exit together. Neither can high-yield market participants feel assured that investors have learned their lesson with respect to buying highly default-prone issues. Measured by concentration of issuers' bond ratings in the lowest-quality tier, 2004's crop of new issues was the riskiest ever.
High-yield derivatives represent yet another reason for caution. They were immaterial in 1989–1990, but now constitute a sizable business. Credit default swaps provide investors and speculators with new ways to manage risk, and in theory should curb volatility. Unfortunately, trading in high-yield derivatives is not yet a mature market of unquestioned depth and breadth. As a result, the availability of souped-up, high-yield trading vehicles may actually intensify volatility during the present downturn.
In short, the next couple of years may not prove as tumultuous as the Great Debacle, but neither should investors count on a smooth ride.
Martin Fridson is the founder of FridsonVision, an independent provider of high-yield research (www.leverageworld.com)