Junk Yields Fail to Deter Investors Seeing No Recession
The world’s largest junk-bond market, which lost 26 percent in 2008 as credit froze, is signaling Europe’s debt crisis, China’s slowdown and America’s rising jobless rate don’t add up to another U.S. recession.
Returns this year of 5.2 percent on the more than $1 trillion of U.S. high-yield debt outstanding exceed the 4.4 percent for all of 2011, Bank of America Merrill Lynch index data show. Yields average 7.81 percent, compared with 8.04 percent for all of last year.
Rather than dumping debt of the neediest borrowers as economists lower their growth forecasts for 2012 to 2.2 percent from 3 percent a year ago, firms from Neuberger Berman Group LLC to Phoenix Investment Adviser LLC are betting that any decrease in the expansion pace won’t be severe enough to cause mass defaults. Offerings of $138.7 billion are second only to the record pace of $173.2 billion this time last year, according to data compiled by Bloomberg.
“We’re constructive on the market,” said Thomas O’Reilly, a money manager in Chicago at Neuberger Berman, which oversees about $200 billion. “Valuations are very cheap right now relative to default risk,” said O’Reilly, who forecasts returns of as much as 12 percent by year-end.
Signs of stress in the market for U.S. speculative-grade debt, ranked below Baa3 by Moody’s Investors Service and BBB- at Standard & Poor’s, aren’t increasing as they did the last two times the European crisis flared.
The extra yield investors demand to own U.S. speculative- grade debt rather than Treasuries widened 144 basis points, or 1.44 percentage points, to this year’s high of 723 basis points on June 5 from the low on March 19, according to Bank of America Merrill Lynch index data.
That compares with a jump of 294 basis points in the two months preceding last year’s high of 910 on Oct. 4 and 159 basis points in a similar period before the peak of 727 on June 11, 2010, index data show.
Even with spreads within 4 basis points of the 2010 high, average yields at 8.35 percent on June 5 compare with 9.48 percent two years ago, Bank of America Merrill Lynch index data show. That’s partly because average Treasury yields fell to 0.91 percent as of June 5 from 1.97 percent.
“I’m a lot more interested now,” Andrew Feltus, who co- manages about $11 billion of high-yield debt at Pioneer Investment Management Inc. in Boston, said in a telephone interview. “Maybe what high yield is really telling you is that the Treasury market is too rich.”
Junk-rated companies have defaulted at a pace below 3 percent for the past 16 months ended April 30, the longest such stretch since before the collapse of Lehman Brothers Holdings Inc. in September 2008 caused a credit seizure, S&P data show. High-yield debt is considered more likely to default than investment-grade bonds when earnings tumble in an economic contraction.
The trailing 12-month default rate in the U.S. climbed as high as 11.58 percent in November 2009 from 2.86 percent in September 2008, S&P data show. That compares with an estimated 2.6 percent rate in May and a three-decade average of 4.5 percent, according to Diane Vazza, head of global fixed-income research at the New York-based ratings company.
S&P forecasts a default rate of 3.6 percent by March 2013, meaning 55 issuers would need to default in the prior 12 months. That’s 17 more borrowers than in the period ended in March of this year.
The Moody’s Liquidity-Stress Index fell to a record low 3.3 percent in May, showing most borrowers can meet their obligations and covenants over the next year, from 4.2 percent in the same month of 2011. The index, which falls when measures such as borrowers’ cash flow and access to capital improves, reached a peak of 20.9 percent in March 2009.
“We’re going to see defaults remain very low,” Gershon Distenfeld, director of high-yield credit at AllianceBernstein LP, which oversees about $20 billion of high-yield debt, said in a telephone interview. “We just went through a default cycle where the weakest companies were thrown out, and most other companies just don’t have liquidity needs over the next two or three years.”
Debt burdens at U.S. speculative-grade companies have also dropped below levels from before Lehman’s collapse. The ratio of debt to earnings before interest, taxes, depreciation and amortization among high-yield issuers has held at 3.9 for the past three quarters, compared with 4.3 in the second quarter of 2008, according to JPMorgan Chase & Co. data. The level reached 5.2 in the third quarter of 2009.
Current growth should be strong enough to sustain coupon payments on junk-bond holdings, according to Jeff Peskind, chief investment officer of Phoenix Investment Adviser in New York.
“It really makes us buyers at times like this,” Peskind, who oversees $470 million of high-yield debt and estimates the bonds may return 7 percent to 10 percent in 2012, said in a telephone interview.
The opportunity for gains through high yield may recede if European leaders fail to stem the region’s debt crisis, bringing a new period of risk aversion.
While the Moody’s liquidity index is at an unprecedented low, pressures will mount should contagion spread across the Atlantic Ocean to the U.S., impeding cash flows or making it harder to refinance debt, the ratings company said. The index shows the ratio of companies with the lowest liquidity rating to the total number of graded companies.
Evidence of deceleration is already increasing. In Europe, government leaders are struggling to contain fiscal imbalances that are curbing demand for goods, with German exports declining in April for the first time this year. The crisis intensified last week as Fitch Ratings cut Spain’s credit grade to BBB, within two levels of junk, citing the cost of recapitalizing the country’s banking industry and a lengthening recession.
Spanish borrowing costs are rising, with the 10-year yield climbing 20 basis points to 6.71 percent as of 5 p.m. in London, after earlier reaching 6.83 percent, the highest since the euro was introduced in 1999.
China’s one-year benchmark lending rate was lowered for the first time in more than three years to counter what Premier Wen Jiabao has called increasing downward economic pressure on the world’s second-largest economy. U.S. employers added the fewest workers in a year last month, with payrolls climbing by 69,000, less than the most-pessimistic forecast in a Bloomberg News survey, and unemployment rising to 8.2 percent.
Declining debt burdens among U.S. high-yield issuers also are stalling as higher-quality companies borrow more to exploit yields near record lows and as earnings growth declines, according to Morgan Stanley analysts led by Adam Richmond, who have an overweight recommendation on the debt.
Anxiety in the high-yield market probably won’t reach last year’s levels unless Europe continues to deteriorate, the New York-based analysts wrote in a June 1 report.
High-yield bonds are now undervalued by about 107 basis points relative to U.S. government securities, according to Martin Fridson, global credit strategist at BNP Paribas Investment Partners.
The average bond price among U.S. high-yield issuers dropped below par May 21 for the first time since January, Bank of America Merrill Lynch index data show. The debt traded at 98.23 cents on the dollar on June 5, compared with a high of 102.2 cents this year on March 2.
“The good news on that is that if you’re a value investor, this is something you should consider,” Fridson, who started his career as a corporate debt trader in 1976, said in a telephone interview. “The market is still not indicating that there’s a high probability of recession.”
Even the worst-rated junk debt with ratings of CCC and lower, which S&P says are “currently vulnerable to nonpayment,” have returned 7.9 percent this year, compared with a 1.4 percent drop in 2011.
The U.S. economy’s 2.2 percent expansion will follow last year’s 1.7 percent, according to the median forecast of 93 economists surveyed by Bloomberg. In June 2011, 66 economists forecast growth of 3 percent for this year. The economy contracted 3.5 percent in 2009 during the last recession.
While slowing growth drives down the value of stocks as profits deteriorate, bond investors depend more on the cash flows and may still see gains.
“You don’t really care if the economy is growing at 2 percent, or 3, or 1.8, as long as it’s growing fast enough for you to get paid your money back,” Peskind said.
Sprint Nextel Corp. (S) of Overland Park, Kansas, and hospital chain HCA Holdings Inc. (HCA) are the largest borrowers of U.S. high- yield debt, a market that’s more than doubled in size from $436.6 billion in November 2008, Bank of America Merrill Lynch Index data show.
Inflows to junk-bond mutual funds this year of $18.5 billion are more than double the amount added during all of 2011 even after the biggest weekly outflow since August in the period ended June 6, according to EPFR Global data. Demand among institutional clients is “strong,” said Neuberger’s O’Reilly.
Rising relative yields on junk bonds aren’t signaling a return to negative growth, making the debt attractive, according to Margie Patel, a money manager at Wells Fargo & Co. in Boston who oversees about $1 billion.
“High yield is too cheap for the fundamental risk,” Patel, who began her career in investment management in 1972, said in a telephone interview. “Spreads are very, very attractive.”
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