Barron's: For Junk-Bond Investors, a Time to Turn, Turn, Turn
By JENNIFER ABLAN
FOR HOME BUYERS, IT'S ALL ABOUT location, location, location. For high-yield bond investors, it's all about rotation, rotation, rotation.
As with the better relative performance in quality stocks, bond managers these days have been rotating out of junk in the lower end of the quality spectrum and into the higher end.
With "limited" appreciation potential in nearly all speculative-quality bonds that pay only single-digit yields -- especially in triple-Cs, the low end in terms of credit quality -- "the margin of error is so low," says Kingman Penniman, director of research at KDP Investment Advisors, a high-yield research firm in Montpelier, Vt. "That is why bond managers have become sensitive to credit selection."
As in the stock market, where companies with negligible earnings or worse fared best last year, the junkiest junk has rallied the most. Triple-Cs posted a total return of more than 60% last year, while single-Bs returned 26%. Bonds rated double-B -- the high end in junk land -- generated 19.5% returns.
Put another way, triple-C bonds were priced at an average 51 cents on the dollar at the market's low in October 2002. Currently, they fetch 92 cents.
But now, Penniman and other pros say, investors are rationing credit for risky issuers or new-deal structures.
Tuesday, for the first time in many months, a high-profile junk offering was canceled after investors demanded yields that the issuer, Calpine, deemed too dear.
"Calpine's love affair with the high-yield market suffered a setback when investors declined to participate in the energy merchant's $2.35 billion refinancing of bank loans due in November," writes Kimberly Noland, director of high-yield research at Gimme Credit.
Calpine, a California-based energy company that operates in North America and the United Kingdom, has been struggling to bolster its balance sheet and return to consistent profitability in an energy market characterized by weak demand and rising fuel prices.
With about $17 billion in debt, Calpine is one of the biggest borrowers in junk land, and "people have to retain diversity in their portfolios," says Noland. "If something goes wrong with Calpine, it can [produce] a big hit." Calpine's senior unsecured debt is rated Caa1 by Moody's Investors Service and triple-C-plus by Standard & Poor's.
The company had offered two tranches of nonrecourse debt with a yield of 11.25% on the fixed-rate portion. The paper would be secured by assets of a subsidiary (Calpine Generating LLC, or CalGen) that would own and operate 14 power plants -- $1.3 billion of first-priority senior secured terms loans and $1.05 billion second-priority senior secured notes.
But Noland says the revenue necessary to cover debt service and operating expenses would be paid largely from a contract with another Calpine entity.
"Investors were therefore concerned about 'counterparty' risk, given the weakness in Calpine's business overall," Noland observes. "Pesky provisions that permitted assets and dividends to be withdrawn from CalGen to the detriment of bondholders contributed to the deal's demise. We expect the company to go back to the drawing board and devise a way to guarantee investors a cash-flow floor," she adds. Calpine said it would try to tap the market in June.
Two days after pulling its bond deal, Calpine reported fourth-quarter results, which Noland reckons were "weak." The company said it had earned $119.6 million, or 29 cents a share in the fourth quarter, compared with a year-earlier loss of $25.2 million, or seven cents. But asset sales and accounting changes played a big role in the rebound. Calpine's liquidity position is forecast to fall to a little more than a billion at yearend from $2.3 billion at the end of 2003.
Calpine expects a power-market recovery by 2005, and believes that even without one, it can bump along in 2005 at cash-flow break-even by cutting capital spending. "The refinancings accomplished last year have bought it time, pushing significant debt maturities out until 2007," the Gimme Credit analyst says.
"However, if demand takes longer to revive, which is possible, given the oversupply of generating capacity in many of Calpine's markets, cash flow could be pressured as revenue" locked in under long-term contracts slips further. (The overall utility industry's woes were underscored ironically Wednesday, when Fortune magazine announced that power-company executives and industry analysts had voted Calpine as the most admired company in their business.)
Calpine's unsecured debt, now deeply subordinated to secured financings, is "a long-dated option on the power market recovery with high current yield," Noland writes. The second-priority secured notes, she adds, offer "a reasonable bet at yields near 11%."
KDP's Penniman views Calpine's canceled offering as a "further indication of a new environment that we are in." Simply put, investors want to make sure that they are being reasonably compensated for the risk they are taking. That means they want deeper discounts and higher yields than much of the junk market is offering. |
