New Issue "Premium" and its Relation on Secondary Prices

Before I get to the meat of this post, I would like to highlight to readers a very interesting quote from Jeffrey Gundlach, legendary bond investor and founder of DoubleLine Capital, in an interview with Barrons:

"Gundlach's cautious take on high-yield is the result of an aperçu or intuitive flash he had several weeks ago, that the yield spread between high-yield and government bonds should be calculated using the 20-year government bond, rather than the entire Treasury yield curve. That's because high-yield paper, though maturing sooner than 20-year bonds, shares similar price volatility. The current 300 basis-point, or three percentage-point, spread between yields in the high-yield market and on 20-year bonds is as narrow as it has been at any time in the latest credit cycle, he notes."

While I do not have the data in front of me, this is an interest pronouncement and echoes my feelings that credit markets (high yield/bank debt/distressed [to a lesser extent]) are overvalued. I do not know if it will be next week, or next month, or even 2013, but I believe an investor is not getting compensated for taking risk in the leveraged finance markets. Unfortunately, the primary market, being as wide open as it is allows speculative issuers to extend their maturities out hence lowering the near term expected default rate which is bullish for credit.

According to JPM's Peter Acciavatti: "As such, institutional loan issuance is tracking at an annualized pace of $320bn, versus the previous record of $387bn in 2007 (predominately in 1H). When combined with $62bn of high-yield bond volume YTD, total leveraged credit new-issue volume is tracking at an annualized pace of more than $640bn, versus $457bn in full-year 2010."

That is a lot of credit.

Any issuer would be foolish right now not to aggressively reprice their bank facility or significantly relax (or remove) covenants. And every banker is out there telling CFOs and Treasurers: "If at any point is there a time to do a big M&A / debt financed stock buy back / stuff coffers, now is the time." Private equity is salivating at financing costs, so much so, that a good friend of mine at one of the most respected private equity firms out there said they have to step back from deals because sponsors are getting irrational with multiples justifying cheap leverage.

To the point of the post: Despite the large number of deals across the rating categories, the enormous inflows of capital from the retail and institutional side seem to be dwarfing them where most deals are still widely oversubscribed (this is the case in IG as well, possibly more so). Some deals have not fared as well (JNY 6.875% for instance), but most "better quality deals" have effectively turned into a food fight. And, more so than I can remember in recent pasts, dealers are putting out "whisper talk" substantially wider than where deals are pricing - to the tune of 25-50 bps back from secondary trading levels.

What is happening though, is that these better quality deals are getting priced INSIDE secondary trading levels. This creates a tightening of the entire complex which seems counterintuitive (i.e. more debt leads to more leverage leads to higher default probability). Furthermore, these new tighter prints then become relative value comps for issuers in the same industry tightening up more credit along the line.

As spreads tighten across capital structures and across the industry (for equivalent rated bonds), high yield returns increase. Higher ex-post returns, again counter intuitively, lead to more capital flowing to the space which exacerbates the cycle with primaries printing at even tighter levels.

You would expect that as the syndicate desks tightens up pricing there would be significant amount of "drops" to come to a more reasonable supply / demand balance. The problem is, many investors (I have been guilty of this in the past), have done the work on the issuer and will "suck it up" and take the 25-50bps cut in yield despite the offering not being priced as attractively as before. Further, as a nice chunk of the leveraged finance deal making YTD has been refinancing, funds that want to maintain exposure to certain issuers need to make sure they get their bonds - they will pad their orders creating a situation that many value investors do not like to find themselves in: Irrational / uneconomic buyers. Buying for technical reasons is irrational and will create price movement errors on the upside.

I much prefer buying from irrational/uneconomic sellers that sell a stock because it was kicked out of an index, or because a bond got downgraded to CCC, or a company is filing Chapter 11. In those instances, the "technicals" are working for me, my potential return has increased, and my potential downside has decreased. That is the opposite of the credit markets today. I hate to use the term "bond pickers market" (it sounds ridiculous), and instead will use the term "avoid land mines market" Shorting the credit market in aggregate while selectively playing credit stories you believe in and waiting for uneconomic sellers to arise throughout the year is the prudent way to navigate this market. For those interested, and I will do a post on this at some point, I think buying protection on certain tranches of either HY CDX tranches (or the vanilla HY15 index itself) or certain tranches of the IG15, which is much cheaper, and has greater skew (cost versus upside) makes sense, especially for those interested in tail hedges.