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12/14/2011

How Bond Plays Work in a Market of Global Systemic Uncertainty


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We recently spoke with Glenn Reynolds, CEO of CreditSights, who offered us some straight talk on how global credit market risk is impacting the broad capital markets. Reynolds will be a speaker at the upcoming NYSSA conference, Market Forecast: Turbulent Times, to be held on January 5.

Here he explains why he recommends a blended strategy of investing in high-yield corporate bonds as an equity surrogate and investment grade bonds as a defensive play to navigate what is likely to be continuing systemic market uncertainties.

[FPP:] What is the most critical macro risk factor of the market at the moment?

[Reynolds:] You don’t have to be a rocket scientist to know it’s the European debt crisis. In 2008, Lehman brought to the household level an awareness of how systemic risk in the banking sector can seriously hurt both the debt and equity markets. So the headlines around Europe are still scaring a lot of people beyond institutional investors. Just watching the stock market is enough to hammer it home.

Right now risk premiums are high and confidence is low. One big question is, “Will there be a monster risk rally if Europe muddles through this crisis?” Or should we just get the canned food and hide the kids if it doesn’t? It’s not the best of times to be trying to develop a portfolio strategy. But you have to.

[FPP:] What is unusual about how the Euro market is behaving now?

[Reynolds:] The euro currency market is very young and is just moving out of its preteen years. So there is not much history. Given the combination of leverage, high correlation, and systemic fear, the Euro issues are infecting all risk assets. For example, right now high-yield credit assets in the US are priced relative to investment grade assets more like they would be in a high default market. Incremental yield for the high yield index versus the investment grade index is well over 100 percent of investment grade yields. That is more like stretches in 2009 and in 2002 after WorldCom when double-digit defaults were the norm. Meanwhile defaults are forecast for more like 2 percent next year and many risky borrowers have already extended out to longer maturities. Basically, many do not have to refinance. It is hard to see the path to a default spike. Maybe an increase but not a spike.

When the bank system falls out of bed as we are seeing in Europe and the systemic risks are hanging over the banks’ heads, risk appetites and secondary liquidity gets crushed. High yield price declines are tied more to weak bids and bad secondary market support by the banks than actual default expectations.

[FPP:] Is there a danger that the era of the Euro is coming to an end?

[Reynolds:] We have been watching this since it hit the fan in May of 2010 and here we still are wrestling with solutions. You don’t have to be a World Cup soccer fan to see these European countries have their differences and they won’t be easily worked out. Europe is a pretty diverse place. It is like putting a conservative from Lubbock, TX, in the same room with a liberal from Greenwich Village—there is not likely to be a meeting of the minds immediately.

The longer this goes on, the greater the risk that the decisions move from the policy makers to individual voters. In the tradition of democracies, they might “throw the bums out of office.” Europeans like austerity even less than Americans. They grew up with a social safety net so there is a real risk politically that voters in the financially healthy countries will rebel for one set of reasons and [voters] in distressed countries for another.

It could also be that the Germans could say “we will get through this on our own.” That is the big fear. Then France comes under siege and the guys at Moody’s and S&P come marching down the street with a conga line of bears. We still think the risk of a full break-up of the eurozone is low since the stakes for everyone are too high for that to happen.

[FPP:] You are saying that you think Europe will muddle through and that even in a scenario where the risk premiums remain high and confidence low for some time the credit markets are a good place to be? Why is that?

[Reynolds:] The systemic crisis we are facing now is as similar on the downside for the banks as it was in 2008, but households are much stronger now than they were then. Household leverage has come down. Debt service ability is higher at low interest rates. Many people do have the discretionary income to spend. Personal consumption expenditures are resilient. You also see it in the growing base of consumers. You do have 8.6 percent unemployed, but the flip side is you have over 91 percent employed. In the banking sector, we do not see a full 2008 flashback playing out since we see the eurozone holding it together in the end and also supporting banks as needed.


Market Forecast


[FPP:] So you think under this scenario there is good value in a rate play on higher yield corporate bonds coupled with a defensive risk profile in investment grade bonds. Can you explain why?

[Reynolds:] Interest rates are likely to stay low because of systemic issues. The past is not prologue but you have to ask yourself, “Is there going to be upward pressure on rates or tighter liquidity in the marketplace from central bank actions?” It is pretty easy to see we will have more liquidity support and not less, or at least the same amount.

High-grade nonfinancial corporate bond issuers are in very good shape. There has been record high-grade refinancing, locking in attractive terms. Default risk is very low in the nonfinancial sector even with a systemic crisis debate. Investment grade indices still include a lot of bank paper but investors can treat many corporate issuers, excluding banks, as defensive assets.

For investors seeking cash income in a low-rate market, it is a challenge since the curve has flattened out more at the front end but is steeper on the long end. It involves taking some interest-rate risk in some cases.

Many credit assets have outperformed equities. If you look at trailing returns on equities over the last 10 years, S&P 500 returns are less than today’s current yield on the high-grade index. That is just high grade. The S&P has returned less than 3 percent per year over this period while even today high-grade corporate bond indices yield around 5 percent.

The US high-yield index has outperformed equities in total return over trailing 2, 3, 5, and 10 years. We consider high yield as an equity surrogate in such markets as today’s, based on relative return versus risk. Real returns are the objective metric. In high yield, we have current yields now that are consistent with equity returns over long-time horizons for equities even if not the bull markets of the 80’s and 90’s. If we do see things get a lot uglier in Europe, riskier assets—both high yield and equities—will all underperform high-grade bonds. But at least you get the cash coupon in high yield and that eases some of the pain vs. equities. Around 8 percent in cash per year is worth something.

Even in a really bad year where we go to 10 percent default rates, that means 90 percent of your high-yield bond portfolio is paying and it then becomes a matter of recoveries on the 10 percent that default. Chances are, in such a down market, that if you are heavily weighted in equities you are in negative return territory with minimal cash income to show for it. With bonds, you can clip the cash coupon on the 90 percent of the high-yield universe that is not defaulting. If you can avoid the losers and face below average defaults, that’s even better obviously.

People have to plan for multiple eventualities—equity can make up a lot of “real estate” in a hurry in total return, but alternatives like high yield with equity-like real returns play a role. Big moves upward after downdrafts go under the heading of “volatility” though and do not add up to impressive annual returns. These days there are very good risk return opportunities for anyone with a balanced portfolio looking across credit and equities. But cash income matters. And you find high cash income in high yield.

–Susan Arterian Chang
Susan Arterian Chang is a financial writer based in White Plains, NY.

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