Junk Bonds: A Brighter 2008?

S&P thinks high-yield issues could be a good investment in the coming year, as investors shake off their aversion to risk

From Standard & Poor's weekly investing newsletter

Junk just ain't what it used to be.

Year-to-date through Nov. 15, high-yield bonds returned 3% vs. a total return of 7.7% for U.S. Treasuries. The relative outperformance of Treasuries can be attributed to many investors' flight to safety in 2007. But in 2008, many market prognosticators are expecting a much better year for high-yield bonds.

An intriguing analysis by T. Rowe Price (TROW) and JP Morgan (JPM) shows so-called problem industries—financial services, retailers, housing, and consumer products—represent only 13% of the high-yield asset class. The sectors that represent the most—energy, utilities, and health care—"should be resilient even if the economy slows," says Mark Vaselkiv, manager of the T. Rowe Price High Yield (PRHYX) fund. What's more, he's very excited that "world-class companies like Alltel, Texas Utilities, and First Data Securities are entering the high-yield market."

To be sure, the outlook for high-yield bonds will depend on the overall health of the U.S. economy in 2008, he says. "We could see strong returns if the current financial-services crisis stabilizes [and there isn't a recession]," he states. "If the crisis continues and we head into a recession, however, spreads would widen further and performance would be more constrained."

Advantage of High-Yield Bonds

David Wyss, the chief economist for Standard & Poor's, pegs the recession risk at 40% over the next 12 months. He acknowledges that U.S. housing weakness and high energy prices, along with billions in writedowns at financial institutions, have sparked fears of slowing employment and wage growth among investors. Although Wyss expects U.S. gross domestic product growth to slow significantly over the next three quarters, he expects a recession to be avoided. He predicts growth will bottom at 0.7% in the first quarter of 2008.

But what happens if prognosticators are wrong? Vaselkiv doesn't see a jump in default rates unless corporate credit quality significantly deteriorates. The yield advantage of high-yield bonds should provide a cushion in the event of a rise in defaults, he says. As of the end of November, the Merrill Lynch High Yield 100 index offered a yield of 8.528%. By contrast, the 10-year Treasury was yielding 4.025%.

S&P Ratings Services, which operates independently from S&P Equity Research, believes default rates will remain below historical levels.

Some Default Uptick Likely

"The U.S. speculative-grade default rate remains suppressed and is likely to post a year-end, 25-year low of close to 1%," says Diane Vazza, a managing director for S&P Ratings Services. "In the next several quarters, we expect the default rate to escalate based on the cumulative impact of the changes in the credit-pricing environment."

Vazza also cites the slower pace of economic growth for the potential uptick in default rates. She expects default rates to accelerate in the second half of 2008 and into 2009, and she estimates a speculative-grade default rate of 3.4% by the end of October, 2008. Although that's higher than current levels, it is lower than the 4.5% historical average.

Putting that default rate prediction into context, it means 56 issuers must default. By contrast, only 14 U.S.-based issuers have defaulted so far this year.

Recommended Funds

"Typically at the inflection point in the credit cycle, a higher range of variability surrounds the forecast and our optimistic and pessimistic projections indicate a low forecast of 2.4% and a high of 4.4%," Vazza says. "A low forecast would be consistent with a default count of 39 (there were 21 in 2006), whereas a high forecast would require 72 defaults. We currently have 74 issuers that are weakest links—those rated B– or lower by us with a negative CreditWatch listing or a negative outlook."

There are many mutual funds specializing in the high-yield corporate bond market. Screening for those with a recommendation from S&P Fund Services, a minimum initial investment of less than $10,000, and no front-end load, S&P's weekly investing newsletter The Outlook identified these funds: Fidelity Capital & Income (FAGIX), Fidelity High Income (SPHIX), T. Rowe Price High Yield (PRHYX), and USAA High-Yield Opportunities (USHYX).

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