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.
