The high yield market traded off considerably during the last two months of the third quarter on concerns about possible recession and contagion from Europe’s financial problems. August and September were the 8th and 9th worst months in 20 years for the Barclay’s High Yield Index.1 Markets reacted again in a highly correlated way as the desire to take risk generically pulled back across the capital markets. Many have come to call it “risk on/risk off”; August and September were “risk off”.

The economy does appear to have slowed and the situation in Europe did indeed worsen. So, spreads were supposed to widen to take this new information into account. Recessions in particular are bad for high yield investing as financial strains mount on companies with lesser margins of financial safety. But as is the case with any market environment, we have to assess valuation against the backdrop of facts and outlook.

We believe the market has overreacted to this correction and we think there is value at this point for several reasons.

Weak growth isn’t a problem for high yield

We believe the most likely scenario is for weak growth or mild recession, not deep recession. The traditional cyclical industries never built the excesses that you typically see in recessions. The trajectory of the Gross Domestic Product (GDP) growth is never perfectly stable; it moves around. Slow growth lends itself to recession scares because the wobble is simply more likely to include some periods that indicate decline. We think that is what is happening now.

Slow growth may not be good for those looking for work nor for the owners of companies, but it’s enough to pay the creditors, including high yield bond investors, and creditors come first. While the ultimate upside belongs to the equity owners — and that can be tremendous — there might not be much of an upside in this environment. High yield investors only need an economy that is good enough for companies to pay their bills, not necessarily an economy that is good enough to keep their owners happy. The power of the high yield coupon reveals an important reality for high yield investing: sideways may work. High yield investors need companies to be able to service their debts and nothing more. As they pay coupons, that money is pocketed by investors and coupons add up.

Junk bonds involve a greater risk of default or price changes due to changes in the credit quality of the issuer. Data as of September 30, 2011, unless otherwise stated 1 Source: Barclays Capital High Yield Corporate Update, Oct. 1, 2011

Weak growth is helping to keep Treasury yields low. With such a low rate environment, the pressure remains on those attempting to fi nd alternatives with yield. This could cause a drive back to the high yield asset class if contagion and recession fears subside. Flows have moved hand-in-hand with economic uncertainty this year, peaking when markets calm and retrenching during economic angst, such as the U.S. debt ceiling crisis and the S&P downgrade in August. After $6.4 billion left the asset class in August, flows turned positive in September as $1.6 billion entered the asset class and remain positive on a year-to-date basis thanks to a growing number of yield-starved investors.1

Recession fears have caused widening spreads

Market fears of a renewed European debt crisis and renewed global recession have created another round of “risk off” trades, where risky assets are being sold in a highly correlated way. This means that everything with risk has been for sale at the same time, similar to what we saw in late 2008 when all asset classes sold off together. It also means that markets have been heavily technically driven.

Recessions are bad for high yield as they strain heavily indebted companies. But not all companies will perform the same in a recession. Spreads rightly widen when recessions are coming. Since the beginning of 2011, spreads on high yield indices have widened significantly with the majority of it happening in the last couple of months. The Barclays Capital High Yield 2% Issuer Capped Index widened 268 basis points since the end of 2010, with 258 basis points of that occurring in the last two months. The current level of the Barclays Capital High Yield 2% Issuer Capped Index is 847 basis points, putting it well above the ten-year historical average for the index of 645 basis points.2

High Yield is currently cheap given relative health of the asset class

Spreads have widened to levels which may allow some capital appreciation. We believe the market is overpaying for risk of default. Bank of America Merrill Lynch has a spread target of 550 basis points over Treasuries for the end of the year, a move of about 311 basis points from current levels on the Bank of America Merrill Lynch Global High Yield Constrained Index.

 

Overall, we believe high yield is stronger than it was before the last downturn. Simply put, the market took a drubbing last time and hasn’t had the time to build up many new speculative excesses. A lot of weak companies already defaulted in the prior cycle and most market activity since then has been refinancing. That is important because refinancing is not typically as risky as financing for things like acquisitions or expansions. Plus, refinancing has also pushed out upcoming maturities. Many companies have also shown caution in other ways this cycle such as building cash reserves and/or paying down debt. With a stronger asset class it will take a bigger blow to cause major problems and defaults to significantly increase.

1 Source: JP Morgan High-Yield Market Monitor, Oct. 3, 2011. 2 Source: Barclays Capital website. As of Oct. 3, 2011.

Defaults are currently modest. Year-to-date through September, the high yield market has had 8 defaults totaling $7.4 billion. This is below the 10 defaults the market saw in the same period in 2010. The current par-weighted default rate of 1.20%, according to JP Morgan, is well below the historical 25-year average of 4.24%1, although past default rates can be no guarantee of future default rates.

Moreover, the upgrade to downgrade ratio is at an historic high. Credit trends remain positive as upgrades outpaced downgrades for the year with August and September being the only negative months. However, positive monthly trend of upgrades outpacing downgrades prior to August lasted for 23 consecutive months. Also on the positive side, we think we will continue to have more rising stars than fallen angels. We believe many high yield companies are likely to be upgraded to investment grade as gradual credit healing continues.

 

Conclusion

Recession is a risk, but it isn’t assured. Even in recession, the depth and duration of the downturn may not be enough to truly test the asset class. The current weak environment carries with it periods of increased risk of a recession, but we think the track remains slow growth. Given this belief, we see value in the high yield market, especially as the asset class has become much healthier since the global crisis cleansed the market. Thus a low-rate, slow-growth environment, combined with the strong fundamentals in the asset class may make high yield an attractive investment opportunity.

1 Source: JP Morgan Default Monitor, Oct. 3, 2011.

Important Information

All investing involves risk including the risk of loss. Fixed-income securities are subject to certain risks, including, but not limited to, market, interest rate, issuer, credit and inflation risks. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise; conversely, bond prices generally rise as interest rates fall.

High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE

All data provided by Invesco unless otherwise noted. Past performance is no guarantee of comparable future results. The opinions expressed are those of the author, are based on current market conditions as Sept. 30, 2011, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. There can be no assurance that these economic outlooks will come to pass. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any fi nancial instruments and should not be relied on as the sole factor in an investment-making decision. As with all investments, there are associated inherent risks. Please obtain and review all fi nancial material carefully before investing. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The Barclays Capital U.S. Corporate High Yield 2% Issuer Capped Index is an unmanaged index that covers U.S. corporate, fi xed-rate, non-investment grade debt with at least one year to maturity and at least $150 million in par outstanding. Index weights for each issuer are capped at 2%. The BofA Merrill Lynch Global High Yield Constrained Index tracks the performance of below investment grade bonds of corporate issuers domiciled in countries having an investment grade foreign currency long-term debt rating (based on a composite of Moody’s and S&P). The Index is weighted by outstanding issuance, but constrained such that the percentage of any one issuer may not represent more than 3% of the Index. Barclays Capital High Yield Index is an unmanaged index considered representative of fi xed rate, noninvestment-grade debt of companies in the U.S. An investment cannot be made directly in an index. Invesco Distributors, Inc. is the U.S. distributor for Invesco Ltd.’s retail products. Invesco Advisers, Inc. is an investment adviser; it provides investment advisory services to individual and institutional clients and does not sell securities. Each is a wholly owned, indirect subsidiary of Invesco Ltd. invesco.com HYMKT-INSI-1-E 10/11 Invesco Distributors, Inc. Invesco Advisers, Inc. 11101

 

 

 

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