High-risk (yield) debt markets - Swing back to irrational exuberance?

Leveraged/high-yield market prices have risen up drastically over the last 6 months, prompting questions on whether the industry is again building up some of the toxicity that caused the previous melt-down. Reports show that leveraged loan prices rose to as high as 92 cents on the dollar per the S&P U.S. Leveraged Loan 100 index, the highest level since late 2008. Global high-yield debt sales has touched over USD 90 bn this year while US issuances have crossed USD 70+ bn, over 5 times 2009 levels for the same period. In line with high demand for leveraged loan issues, spreads have dropped to record lows, with below-CCC categories trading at just over 9 percent - as compared to the long term average of 12+ percent. Also, the trend has not been limited to issuers from specific sectors, but pretty much across the manufacturing and services spectrum.

Though the economy is definitely better placed now as compared to 2009, it is difficult to imagine that risks associated with the most risky borrowers have dropped that low, especially at this stage in the economic cycle...assuming there in fact is a correlation the market is placing between risk and return!

Just to prove a point, let's take a look at a another activity that is not directly tied, but driven by some of the same growth fundamentals - Leveraged Buy Outs (LBOs). LBO funds have raised the least capital over the latest period since 2004 and large funds including those from Caryle and Madison Dearborne have struggled to close LBO funds. Average fund raising length for buyout funds seeking more than $1 billion is as high as 19 months now as compared to 16 months in 2009 and less than 5 months in 2004, per Bloomberg reports...deal closures have been even slower, resulting in firms sitting on massive piles of uncommitted capital. It is safe to argue that there is greater investor sophistication and 'better' due diligence that happens as part of LBO fund raising and deal closure as compared to traditional credit market activity. Also, given the fact that LBO deals arguably involve better reference credit as compared to that associated with high-yield issuers in the primary market, indicators from a tepid LBO market do not augur well for the high-yield credit market. Unless there is a perverse logic that issuers with the highest risk will see faster pick-up in activity during a period of weak economic growth! Just to clarify, I agree there is no direct correlation in the reference entities for credit in both cases (high-yield credit markets and LBO deals), but it should be the same fundamentals - economic growth and recovery prospects - that logically should underpin both markets.

Perhaps, capital market participants have extremely short memory spans - as this article on a recent BCG study points out,
(http://www.businessspectator.com.au/bs.nsf/Article/Boston-Consulting-Group-investment-banks-revenue-G-pd20100325-3V3FW?OpenDocument),
sliding revenues are possibly making profit-driven firms focus on the next stop for immediate super-profits...despite all the talk on risk-aligned performance measurement and deferred bonuses!

View on April earnings calls - Financials

Quite unlike what many (myself included) expected, markets have continued to rally over the
past couple of weeks. Though not unidirectional through the period, the DJIA has inched almost close to the 11K mark and emerging market indices have continued to rise...the MSCI emerging markets index in fact shot up 1.3%+ yesterday! I still hold on to the view that there has been too much-too fast in terms of market rebound and a short-term correction is imminent.

Having said that, there are some interesting picks worth looking among financial stocks -
with a bunch of earnings announcements expected the weeks of April 12 and 19. Let's take a quick look:

• JPM/JPMC - Earnings expected 14th April. Trading at 45 levels, close to the 52-week high of 47.5 and 5-year high of 52.6. P/E at 20. Though Jamie Dimon's shop weathered the crash better than most others, most of the upside has been factored in and i don't think there is still enough upside left medium-term. However, trading and asset management revenues should look up though credit card losses may moderate profits. Neutral/no directional view.
• BAC/Bank Am - Earnings expected 16th April. Trading at 17-18 levels, close to the 52-week high of 19.1; 5 year number not relevant due to equity dilution post bail-out. P/E NA. Bank Am should show significant gains due to trading and investment banking revenues and loan loss provisions should be tempered enough to beat street estimates. Bullish - can touch 20 post-earnings - watch May strike 17 call options.
• BK/BNY Mellon - Earnings expected 19th April. Trading at 30-31 levels, close to the 52-week high of 33.6, 37% below 5-year high of 49. P/E NA. Custody segment should show growth while international revenues will gain from Mellon's share of business. BNY also has lower loan loass provisions as compared to some of its peers. Bullish - watch May strike 30 call options.
• C/Citi - Earnings expected 19th April. Trading at 4 levels, away from the 52-week high of
  5.4; 5 year number not relevant due to equity dilution post bail-out. P/E NA. Though the US Treasury has announced its intent to sell of its Citi stake (27 and odd %) this year, 7.7
  billion shares on a daily volume of 500 million+ shouldn't cause undue pressure on shares.
  It is reasonable to expect loan loss provisions to moderate & investment banking revenues to climb...though credit card losses can still renmain at high levels. Citi might show good
  margin improvements due to cost rationalization too. Bullish - May strike 4 call options at
  ~0.25 is a good bet.
• GS/Goldman - Earnings expected 20th April. Trading at 170 levels, down from its 52-week high of 193, 25% below 5-year high of 229. P/E of 8.5. Higher fixed income revenues, higher trading revenues in general, stronger M&A and advisory revenues etc should continue to propel growth - though it's difficult to replicate '09 numbers due to lower market volatility/lower spreads. Bullish - May strike 175 call options at ~5.1 is a good bet
• SS/State Street - Earnings expected 20th April. Trading at 45 levels, down from its 52-week high of 56, 43% below 5-year high of 78. P/E of 13. Custody and outsourced securities services should show strong growth while asset management should see gains due to a market trend favoring exchange traded funds. Loss provisions associated with conduits should taper down. Bullish long-term - May strike 44 call options at ~2.7 is a good bet.
• WFC/Wells Fargo - Earnings expected 20th April. Trading at 31 levels, close to its 52-week high of 32 and 21% below 5-year high of 39. P/E of 18. Wells does not have a strong trading desk, and on the other hand has a loan portfolio heavy in optional ARMs and commercial mortgages. This doesn't provide enough reason for any optimism in the short-medium term, and considering current levels, there is a very strong chance of downward movement in the stock price. Bearish - May strike 31 put options at ~1.2 is a good bet.
• CS/Credit Suisse - Earnings expected 20th April. Trading at 51 levels, down from its 52-week high of 60, 32% below 5-year high of 75. P/E of 10. Apart from gains due to significantly reduced exposure to leveraged finance, commercial & residential mortgages, CS should see gains in wealth management, clearly an area which continues to show long-term growth. Neutral-to-bullish - watch May strike 50 call options.

Having said that, it is safer to take bullish bets closer to the earnings dates since a downward market correction (long over-due) might put overall selling pressure interim.