Can the good times keep on rolling?

High yield bonds are having a remarkable year. Spreads over treasuries and gilts have tightened from record highs of about 2,500 basis points in mid-December to 800 basis points, a movement of 32 per cent in ten months. The rally has flattened in the recent weeks, however, and opinion is divided on whether momentum can continue. At one extreme, optimists believe that high yield will be sustained by a strong rebound in the economy next year, particularly in the US, with growth alleviating many default problems, but at the other there is concern that current high default rates might continue or even escalate. “There are two ways of looking at it: glass half full and glass half empty,” says Sandro Naef, fund manager of the Nordea 1 - European High Yield Bond Fund. “If you take the half-empty view, you’ll say to yourself that the market has rallied, spreads have tightened from 2000 to 800-900, and a lot of the good news has come and gone. If you take the half-full view, then you see default rates are levelling off and there are still good returns to be made.” By historical patterns, the early stages of the recovery part of the credit cycle are still playing out. Recessions are often measured from when central banks start to cut interest rates and that usually occurs around 18-24 months after a recession has begun. At this stage, high yield starts to perform. Typically, the repair phase of credit cycle lasts one to two years and recovery lasts a further year. The US Federal Reserve cut rates around two years ago, so on this reckoning there may be up to three years of growth left to run. Default trends support this interpretation. The ratings agencies have lowered their predictions for speculative-grade default rates, from around 15 per cent at the start of the year to 12.5 per cent. For example, Moody’s recently predicted the global default rate will rise to a peak of 12.6 per cent in the fourth quarter and then decline to 4.3 per cent by August 2010. In March, however, the agency had estimated worldwide default rate would reach 14.8 per cent by the end of 2009, falling to 13.8 per cent by February. “We expect default rates to peak at around 12 per cent at year end,” says Henning Lenz, fund manager at WestLBMellon Compass Euro High Yield Fund. “Monthly default numbers are already declining. Moody’s has revised its forecast for 12-month default rates to 4.3 per cent, and we believe a return to the long-term average default rate in 2010 is possible,” he explains. “Historical evidence shows that after a peak, default rates normally decline quickly. The economy is in much better shape and finding its way out of recession. We expect moderate growth in the second half and in 2010. There is always a risk of consolidation after such a strong rally but we believe this will not reverse the medium-term trend which is supported by an improving economic environment.” Other options On a comparative basis, other asset classes may offer more attractive opportunities, however. “At the end of 2008, many high yield credit indices were yielding around 20 per cent,” says Kevin Gardiner, head of investment strategy Emea at Barclays Wealth. “At these levels, the market seemed to us and many investors to be pricing-in an unreasonably-high level of expected loss. Economic recovery and a revival of monetary confidence have subsequently fostered a tremendous narrowing of spreads – on a scale that has helped the market deliver a better return in 2009 to date than the more glamorous market in gold bullion, for example,” he says. “To us, it looks as if the market is now closer to fair value, and we are now neutral on high yield and indeed corporate credit generally in our recommended TAA (tactical asset allocation) portfolios. We do not expect the market to sell-off, but other assets offer better risk/return characteristics from here – most notably, perhaps, equities,” adds Mr Gardiner. For income seekers, however, speculative grade yields are still compelling. Few would argue that yields of 10.5 per cent, or spreads of about 8 per cent over treasuries, are not adequate compensation for the default risk. High yield is also an attractive diversifier as correlation between asset classes shows no signs of returning to traditional divergence levels. For investors who are bullish on the stock markets, the speculative-grade sector is a natural choice as it should outperform investment-grade bonds. “One of the interesting attributes of high yield bonds is their ability to provide both capital appreciation and high current income,” says Paul Karpers, vice president at T.Rowe Price. “With a tremendous recovery since the start of the year, much of the capital appreciation has been realised, but sub investment grade bonds still provide attractive yields, in our view, with the potential for high single digit and in some cases double digit income potential that looks attractive relative to both higher quality debt and equities,” he says. “The high yield market went through a healing phase over the first nine months of the year, with companies looking to defer maturities, reduce leverage, lower their cost structures and otherwise prepare for a difficult environment,” Mr Karper adds. “With evidence of an economic recovery starting to take shape, these companies are poised to enter the next phase which could include merger and acquisition activity or earnings gains that exceed expectations set when pessimism was at its peak. Many companies we invest in moved to aggressively prepare their businesses for the worst as the global credit crisis unfolded,” he says. “The reality is that since even a moderate recovery didn’t seem to be on the cards, the profit gains enjoyed by companies as it has occurred have been that much more robust – leading to tremendous results across high yield bonds,” explains Mr Karpers. “During a recession, many highly-leveraged companies have a near death experience, and the survivors then focus on deleveraging – paying down debt – and that is a fantastic time to buy high yield bonds,” agrees Wesley Sparks, head of US fixed income at Schroders. “Companies are not yet getting into expansion mode, so they’re not doing leveraged buyouts and issuing debt for share buybacks. The exception right now is the highest quality companies which can afford to leverage up, so our view is that there is growing danger in high grade industrials. There have been some deals announced recently since managements see they can lock up 10-year money for 5 per cent, which is an incentive to make acquisitions.” Double dip danger The danger of course would be around a potential double dip for the economy. Companies are relatively cash-rich for this stage in the cycle, and many have tailored their cost structures to endure a double dip, while the reopening of the capital markets is helping those still grappling with the refinancing of loans. “There are still lots of good quality businesses around,” says Mr Naef at Nordea. “Some of the sectors that have had a lot of problems are going to be the ones that do best, because they have cleaned up and recapitalised the business,” he explains. “We like banks because we think that people have forgotten that their trading operations deliver generous cash flows. The value franchises of these banks have been forgotten. We bought Credit Suisse, for example, because we realised that the retail and private banking businesses more than compensated for the loan book. We also still like non-cyclicals because if there is a double U shape, then these businesses would be stable, offering good yields but not extensive risk.” Certain fallen angels are very attractively priced as sentiment has been so extreme. Sparks for example bought Sprint, which overshot when it got downgraded from triple-B to double-B last autumn, when its 2012 bonds were trading at a yield in the mid-teens; the bonds now trade inside of 8 per cent.