With a recession – by common consensus – looming, would anyone in their right mind allocate fresh capital to junk bonds? After all, by definition, they are the fixed income securities most likely to default. As the current crisis plays out, companies with weak balance sheets are most likely to be weeded out.
Indeed, with yields in sub-investment grade corporate bonds running at more than 16 per cent last week, a full 1,360 basis points above Treasury yields (compared with just 590 basis points above Treasuries at the start of the year), the risks would seem perilous. Whereas a month ago predicted default rates on high yield bonds were 6-7 per cent, according to a consensus of analysts, Standard & Poor’s, the ratings agency, is now forecasting that 12 per cent of junk bonds will default over the next two years.
That may well leave high yield investors scratching their heads. After all, the global high yield index is down more than 20 per cent for the year to date, following poor returns in 2007 when the credit crisis began.
However, some high yield bond fund managers believe the worst is over. T Rowe Price, which runs an $800m (£464m, €594m) Global High Yield fund, thinks the bad news is already priced in after the high yield index fell 12 per cent in just two weeks in October.
Mark Vaselkiv, head of T Rowe’s high yield group, says: “There has been unprecedented selling in the last six weeks. During the last bear markets for high yield – in 1990 and 2002 – the recessions were relatively mild, but the severity of the financial services crisis makes this one unique. The recession may last a year or longer, but we think the market has priced this in.”
These are brave words. After all, some stock market commentators proffered similar views after the Dow Jones Industrial Average posted an 11 per cent one-day gain last week. But experienced market watchers simultaneously pointed out that the biggest ever one-day rise in the Dow followed the 1929 crash. And markets took 30 years to re-establish highs after that.
The advantage high yield may have over equities, however, is that they deliver income whereas many companies may be forced to cut or even scrap their dividends to conserve cash.
Mr Vaselkiv says: “The good news is that even if prices drop by another 10 per cent, with 16 per cent income on offer investors have more protection. That is a kind of downside protection that stock markets cannot offer. We can sit here and bump along the bottom of the market and still scratch out returns.”
The T Rowe fund has seen its record of consistently positive returns since 2000 wrecked by the credit crisis. While it managed to eke out a 3.2 per cent return last year, this year it is down 17 per cent, and threatens to post worse 12-month returns than in 1990 when the fund was down 11 per cent.
T Rowe believes, though, that performance is about to pick up markedly, boosted by a host of opportunities thrown up by the current turmoil. Its favourite sector is automotives, in which General Motors and Ford are currently fighting for their corporate lives.
A GM bond yielding 7.2 per cent and maturing in two years can now be bought for 38 cents in the dollar, such is the concern that the carmaker may collapse. So investors buying the bond now would receive a 62 per cent return on their money. Similar bonds issued by Ford are trading at 55-60 cents in the dollar. T Rowe believes these iconic brands would not be allowed to disappear and would be bailed out before they became bankrupt, particularly at a time of political change in the US.
Gaming companies are also attractive, T Rowe thinks. They are highly profitable despite slowing growth and the discounts on bonds such as MGM, Wynn Las Vegas and Harrah’s Entertainment are too great. “They are likely to weather the storm,” says Mr Vaselkiv, who also thinks overseas capital may soon arrive to shore up their balance sheets.
Metals and mining have been a long-time favourite of Mr Vaselkiv’s fund, and offer even greater value since fears of slowing world growth have hit their share and bond prices, he says. Freeport McMoRan, the copper mining company, offers particular value. It has a triple B rating, so is not strictly speaking a high yielder, but with its 2015 bond trading at 79 cents in the dollar, Mr Vaselkiv believes the opportunity is too good to miss. “It is a tremendously profitable business,” he says. “Although it has $7.2bn in debt, its cash position next year should be $6.4bn, according to our analysts, so net debt is very low. Even if we use draconian assumptions for the copper price, this company cannot blow up.”
One of the problems for bonds has been the dash for liquidity by hedge funds, creating panic in the financial instruments of even the most stable companies, Mr Vaselkiv says.
This has encouraged him to invest in more higher-grade companies than normal. He could barely believe his luck when he found last month he could buy a 10-year bond issued by Goldman Sachs trading at 80 cents in the dollar. “This bank houses one of the world’s greatest collection of intellectual capital and is rated doule A. It shows that some high quality companies have fallen to ridiculous prices.”