March 17, 2009
Macro factors weigh heavily
Although you can argue that the high yield sector has already priced in the risk of a Depression, much can still happen to cause spreads to widen further.
A lot of high-yield debt is held by hedge funds and private equity firms. As they face ongoing client redemptions and forced de-leveraging, these funds will continue to be net sellers, depressing prices even further.
In the event of default, recovery rates are likely to be low. Asset recovery is typically based on real estate values, and the likely value of bankrupt companies’ commercial real estate may be insufficient to achieve historical recovery rates of 60-70% on defaulted debt. Recovery rates have already dropped to 20%-40%.
Approximately $680 billion of corporate debt will mature by the end of 2009. With credit markets frozen, issuers are unlikely to refinance that debt.
David Thompson, who manages fixed income portfolios for Highmount Capital, a $1.3 billion New York-based multi-family office, says it is still too early to enter the high yield market. “I am worried about recovery risk, cash flow risk, refinancing risk, and the overall business environment these issuers face,” Thomas said.
Thompson sees the flow of funds into high yield debt as a red flag. “If the rest of the world wants these assets, then it is the wrong place to invest,” he said.
Ultimately, if your forecast includes another 18 or more months of recession, then the best opportunities for buying high yield bonds lie ahead.
Macroeconomic concerns aside, don’t expect diversification benefits from this asset class. We recently wrote about the research conducted by Sebastien Page, of State Street Advisors, and his colleagues [see Why Diversification is Failing]. They measured the upside versus downside diversification value of asset classes against US equities. Ideally, asset classes should have low correlation with equities in down markets (when diversification is valuable) and high correlation with equities in up markets (when investors could use a little less diversification).
By that criterion, high yield debt has an undesirable correlation asymmetry score of 43.8%. But medium grade debt has a desirable score of -20.0%. Page believes high yield bonds suffer in this regard from their important equity component on the downside. “If the company does well, you hold debt. If the company is not doing well, your returns behave more like equity,” he said.
Our thoughts
Among investment grade issuers, 10-year GE bonds currently yield approximately 10%. High yield funds offer an additional 500 basis points. The question every advisor must ask is whether this 500 basis point spread is justified by the risk of junk bonds, as compared to owning a nearly risk-free security.
High yield bonds should play a relatively small role in an investor’s asset allocation. Given this, I’d rather hold the undiversified GE bond than a fund of high yield bonds, some of which I know will default. (If holding an undiversified GE position is unacceptable, then you can own the LQD investment grade bond ETF, which currently yields 7.22 %.)
Lastly, a basic investment principle is that you should always understand the true nature and magnitude of the risks you are taking. That is not possible with junk bonds – you cannot evaluate the credit of every issuer in a fund. Don’t assume that diversification eliminates these risks. Not too long ago, investors bought collateralized mortgage obligations without knowing the true nature of the risks of the underlying assets. They believed diversification eliminated those risks. We all know how that story ended.
Junk is still a four letter word.
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