Junk Bonds: A Rickety Recovery
It could be partly the summer heat, but investors' appetite for risk has begun to shrink since a more sober outlook on the pace of economic recovery has taken hold in recent weeks. And that could put the recent recovery of the high-yield debt market on hold. In a July 7 report, Standard & Poor's Global Fixed Income Research said that the narrowing of the yield spread between high-yield corporate bonds and U.S. Treasury bonds of comparable maturity is likely to take a breather while investors await signals from economic data and second-quarter earnings that will either reignite or discourage demand for speculative-grade debt. Standard & Poor's said the risk premium in the high-yield market had shrunk at an unprecedented rate over the past six months, with the spread of S&P's speculative-grade composite index dropping to 9.71 percentage points over Treasuries on July 1 from 16.47 percentage points at the end of 2008. The average yield for June issues was about 10.5%, according to S&P, still high but lower than new issue yields in the first quarter. And with default rate expectations still high, "investors may need to see a material improvement in both profits and economic data before spreads undergo another round of significant tightening," S&P said. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Cos. ( (MHP)).) The default rate on high-yield bonds hit 9.2% in June and, given expectations of a significant number of defaults over the next three quarters, that rate could reach 14.3% by March 2010, the S&P report said. The pool of companies that face substantial default risk is large, with 142 speculative-grade companies, or 13%, rated CCC+ or lower, and an additional 163 companies, or 15%, rated B-, S&P said. There was a total of $33.5 billion in high-yield debt issued into the market in the prior two months, with the $15.5 billion sold in June evenly split between bonds with BB and B ratings, S&P said. The agency has downgraded 438 speculative-grade companies so far this year, while upgrading just 40 companies. The media and entertainment sector had the largest number of downgrades, 120, and only seven upgrades, while forest products and building materials had 43 downgrades.
A Spooky Unemployment Report Bill Larkin, portfolio manager for fixed income at in Salem, Mass., thinks the high-yield market has reached another inflection point and that investors will wait for more information about the prospects for economic recovery before buying additional speculative-grade corporate debt.
"The [June] employment data kind of spooked people. It brought to light that things may take a lot longer than the market currently expects to recover," which would be problematic for the corporate debt market, he says.
Although the credit market has made great strides to facilitate companies' liquidity needs, parts of it remain closed or aren't functioning properly, says Larkin. The concern is it's still early in the default cycle, and the longer the recovery takes, the greater the possibility that companies trying to refinance maturing debt may be locked out of the marketplace. That would likely cause high-yield spreads to widen again.
Investors who haven't backed away from risk are benefiting from the broader change in sentiment since it keeps the yield spread from narrowing further, giving them an extra 10.5% return above comparable Treasuries, he says. The 50% pullback from the peak spreads last fall may mean high-yield debt is now priced at fair value, given the information about the economy currently available.
"But that puts people on edge and makes them ready to sell and get more defensive," says Larkin. However much investors may appreciate the returns they're getting from high-yield bonds, they want to lock in the gains from the first part of this year, he adds.
How Big an Increase in Defaults? Larkin believes the steeper default rate has already been priced into many of the high-yield market valuations. The information companies disclose during earnings season will help investors get a handle on what the future may hold for the economy. Lack of future earnings guidance by companies won't be taken well. In the financial sector, for instance, which has reported so many asset writedowns up until now, if investors get more disappointments, they're likely to lose patience in that sector, he says.
One factor that may influence the direction of spreads more than earnings will probably be how much defaults increase over the next six months, says Manny Labrinos, portfolio manager of the Nuveen High Yield Bond Fund ( (NHYRX)) in Los Angeles. His fund was up 17.6% year-to-date as of July 7, after losing 24.7% of its value in 2008.
Default expectations have dropped with improvement in the market "because a lot of companies that ordinarily would have hit a wall have been able to come to market [with new issues and refinance] some of their short-term maturities," he says.
While spreads for high-yield bonds are still fairly wide compared with historical levels, "clearly some of the extreme undervaluation in the asset class has been removed because of market appreciation," says Scott Kubie, a portfolio manager at CLS Investments in Omaha. He admits to having slowly reduced some of his portfolio's allocation to high-yield exchange-traded funds, and says he'd be more eager to trim his exposure if he could find other asset classes offering comparable returns and that are more cheaply priced. He thinks the default rate could rise to roughly 12% in the future.
Larkin at Cabot and Kubie both use the iShares iBoxx $ High Yield Corporate Bond ( (HYG)) and the SPDR Barclays Capital High Yield Bond ( (JNK)) ETFs for their high-yield allocation.
Now, "A More Ordinary Credit Recession" Nuveen's Labrinos sees the high-yield market as "relatively bifurcated for now." The bonds issued by companies the market believes will survive have already rallied to trade at up to 90¢ on the dollar, while the bonds of more distressed outfits are still languishing at 20¢ or 30¢ on the dollar in some cases. The latter group is where he expects most of the defaults to come from, particularly in the media and entertainment sector, where companies tend to carry some of the highest debt loads and where advertising revenues have been so damaged by the recession.
"We went from a major financial crisis and liquidity crisis to a more ordinary credit recession," Labrinos says. "High-yield investors, generally speaking, are more comfortable dealing with that kind of environment and it becomes more an issue of returning to fundamentals and doing recovery analysis and liquidity analysis and figuring out who's going to hit a liquidity wall."
The long-awaited rollout of the Public Private Investment Partnerhsip (PPIP), albeit at a much lower-than-expected investment level of up to $30 billion by the U.S. Treasury, could provide investors still looking for higher returns with an alternative to high-yield bonds. Larkin believes the illiquid assets that private investors will be buying off banks' balance sheets will "offer very compelling yields and may be a good component to a high-yield strategy for retail investors." He says he's interested in who will create the first fund that packages these securities in a way that they are more attractive to retail investors, which he expects to happen by this fall.
Labrinos says he thinks the PPIP assets will appeal to a different kind of investor than those who buy high-yield bonds—financial firms and hedge funds, as opposed to mutual fund and pension fund managers.
With so much uncertainty surrounding the recovery—and the pace of defaults by speculative-grade issuers—expect high-yield investors to remain on the sidelines for the foreseeable future.