The corporate high-yield bond market has been riding high this year. Investors enjoyed low volatility and healthy returns of about 11 per cent - more than any other category of fixed-income assets.
Issuers and private equity groups have benefited from easy access to capital as high demand pushed risk premiums lower.
This led to record issuance of $122.7bn of bonds in the US and $66.2bn in Europe, according to Dealogic. Leveraged loan volumes also spiked, with a record $629bn originated across the US and Europe, according to Standard & Poor's LCD, the information provider.
"Every single milestone in high-yield has been exceeded this year," says Jim Casey, co-head of leveraged finance at JPMorgan.
However, analysts say there are signs that the buoyancy of 2006 has left little headroom for further gains. Some warn that this year's ample liquidity has spawned increasingly aggressive leveraged buy-outs and looser lending standards that may have suppressed early symptoms of distress in the market.
Thomas Haag, portfolio manager at Seneca Capital Management, says: "We are starting to have concerns about 2008 and beyond - with higher leverage and riskier debt, there is a chance that today's speculation and LBO activitywill come back to haunt the market."
LBOs made a substantial contribution to both US and European high-yield debt issuance in 2006. In the US, data from Lehman Brothers suggest more than half of the year's supply was used to finance LBOs.
November issuance spiked to a record monthly level of $25bn as several mega-sized deals came to market, including a $5.7bn issuefrom hospital operator HCA and a $5.95bn issue from Freescale Semiconductor.
Much the same was true in Europe, where the high-yield market chalked up impressive 75 per cent year-on-year growth, in part due to mergers and takeovers.
"The growing influx of private equity sponsors in the European capital markets, with their seemingly insatiable appetite for ever larger deals, has been a key driver of issue size expansion in recent years," says Diane Vazza, managing director of global fixed-income research at Standard & Poor's.
Yet investor demand has more than kept pace with supply. Mr Haag says: "This level of supply from LBOs would have been enough to knock the market off the rails before, but the market has barely blinked."
After a difficult year in 2005, which saw a combined $450bn of General Motors and Ford debt tumble into the junk-rated space, many high-yield bond investors returned to the sector. In the US alone, high-yield corporate bond funds saw more than $1.8bn of net inflows in the year to mid-December, according to AMG Data. That compares with net outflows of $11.5bn in 2005.
Hedge fund investors are also playing a growing role, says Mr Casey of JPMorgan, and they participated in all the big deals partly because they are the most easily traded.
"Hedge funds like to have the ability to get in and out quickly. The average high-yield deal this year was $450m, the highest ever by a significant factor," he says.
Eric Tutterow, head of high-yield research at Fitch Ratings, adds: "As the year progressed, investors seemed to reach the consensus that the [Federal Reserve] had engineered a healthy environment for high-yield - an economy that was slowing enough to lessen inflation concerns, but not slowingso much as to raise the spectre of declining corporate profitability."
In Europe, the economic backdrop was also robust, raising few red flags for investors buying risky assets. Gary Jenkins, credit strategist at Deutsche Bank, says: "We have the strongest economic growth on record and the lowest default rates for 25 years, so you have a situation where yields are very low. To find higher returns you need to invest in high-yield bonds, which are no longer seen as a big risk in terms of default."
Analysts across the street say that low defaults appear to have reduced investors' risk aversion, as shown by low equity market volatility readings and the low cost of insuring against corporate defaults in the derivatives market.
The problem is that investors may not be adequately pricing risk, since market liquidity has made it possible for risky companies to borrow on increasingly favourable terms, often using the proceeds to boost their share prices.
As a result, leverage levels for high-yield bond deals have been creeping higher, with US companies issuing debt worth on average 4.4 times their earnings before interest, tax, depreciation and amortisation.
According to data from Standard & Poor's, the ratings mix of new deals in 2006 saw a steady deterioration. In the US market, a sizeable $39bn of debt, accounting for about 30 per cent of total issuance, was rated B- or lower.
And while thus far there have been few signs of an abrupt reversal of fortune for high-yield in 2007, analysts say that the market may have priced in too much good news.
Additional reporting by David Oakley in London
