Markets like this one are the enemy of solid fundamental analysis. It can cause otherwise good traders to start just guessing, resulting in either panic selling or simplistic buying (you know the old, “if you like it at $30, you love it at $15!” trade.)
One area where the value proposition is relatively simple is high-yield bonds. Bonds offer a very straight forward fundamental risk-reward situation: the reward is the yield, the risk is defaults. As of 1/25, Lehman’s High Yield Index yields 10.08%, or 672bps over Treasuries. That’s your reward in hard numbers. So what about defaults?
The following chart shows annual credit losses (that’s defaults less recovery) for high-yield bonds since 1982. The data is from Moody’s 2007 Default Study, and includes all Moody’s rated high-yield bonds.
I've labeled the recessionary periods of 1990-1991 and 2001. So in 1990, if you had owned the entire universe of Moody’s rated high-yield bonds, you would have suffered credit losses of 6.3%. The greatest credit loss rate of the last 25 years was in 2001 at 8.3%. So if the 2001 experience were to repeat itself in 2008, investors would earn 10.08% in interest versus 8.3% in credit losses. Determining the exact total return would depend on the timing of the defaults, but the number would almost certainly be positive.
So could defaults be worse in 2008 vs. 2001? Remember that the 2001 recession was all about over-investment in technology and telecommunications. There were also some very large defaults that were due to unique circumstances, namely Enron, Worldcom, and various airlines. If there is a recession in 2008, it will be about over-investment in housing. Very few high-yield issuers are involved in the housing market. Virtually all banks, brokerage firms, mortgage insurers, etc. are investment grade.
Of course, its possible high-yield spreads move even wider. According to Lehman Brothers, the high-yield index spread got as wide as 1036bps in 2002 vs. only 672bps today. Perhaps spreads will widen further, but don’t get caught fighting yesterday’s war. In 2001-2002, the corporate bond market suffered from a series of accounting scandals, which resulted in investors questioning the veracity of financial statements in general. That fear hit the high-yield market directly. Today the fear is related to mortgage lending, a business dominated by investment-grade companies.
For that matter, the 1990-1991 period was also unique, in that it saw the demise of Drexel Burnham Lambert. Drexel and its star banker Michael Milken created the modern high-yield market, and for several years was the primary market maker. Drexel’s fall from grace put the future of high-yield in serious doubt.
If we do have a recession in 2008, high-yield default rates will certainly increase. But at today’s valuation levels, high-yield already has a recession priced in. Given that there is good reason to believe credit losses will be no worse, or perhaps even better than the last two recessions, high-yield looks fundamentally attractive.