Friday, October 31, 2008

"20% high-yield defaults? Don't underestimate the power of the autos!" - Accrued Interest On Monday the yield on the Merrill Lynch High Yield Master index reached a shocking 19.6%. That yield is admittedly enticing, but the real question is, how many of those high-yield bonds might default? In short, if we're getting 20% yield, could we wind up suffering 20% losses in defaults? According to Moody's, the largest default rate in history was 15% in 1933. In the post Depression era, there have been three years which produced double-digit default rates: 1990 (10.1%), 1991 (10.4%) and 2001 (10.6%). The average recovery rate (i.e., the amount the bond is worth immediately after default) is 32% for the three peak default years. So if a portfolio suffers 10% in defaults with 30% in recovery, it has actually suffered 7% in total credit losses. That history would seem to favor high-yield, even admits an ugly economic forecast, given the initial yield of 20%. But risks remain. First, the proximate cause of most corporate bankruptcies is either an inability to roll over debts or a demand by creditors for collateral which the company cannot obtain. Right now roll-over risk in high-yield is higher than any time since at least the early 90's. Junk-rated companies can obtain funding through one of two routes, either bank loans or the public bond market. But neither of those are open to lower-quality borrowers right now. There have not been any new high-yield issues for the entire month of October. And banks remain highly unwilling to lend to anyone, much less to high-credit risk firms. Should the credit markets thaw somewhat in the near term, new deals may be possible. But even if that happens, how many companies will be able to operate where the cost of debt is 20%? Some companies look for ways to borrow in the secured market, where companies pledge specific assets to lenders, which in effect subordinates existing bond holders. Then there is the 900-pound gorilla in the junk bond market: the autos. Ford and General Motors alone make up about 7% of the high-yield index. Recent stories in the media suggest that GM will need a loan from the government to complete a merger with Chrysler, and even then there are no assurances that the companies significant problems can be solved. There are also stories that GM sought help from Toyota. Sounds awful desparate. In fact, I'd argue that a bankruptcy would be better for the American auto industry long-term, as it would allow firms to focus on production rather than dealing with an out-dated union structure. That's the path the airlines followed in 2001-2002. If high-yield defaults follow the "normal" recessionary pattern of about 10% defaults, but GM and Ford default as well, that would bring total defaults to about 17%, disturbingly close to the 19.6% yield on the index currently. Given the extremely high rate of interest on high-yield currently, the odds are good that high yield will produce positive returns over next 3-years. Even if defaults spike in the next 12-18 months, investors will likely be well-compensated for the credit losses over a longer period of time. But if one is to take that tact, bear in mind that the near-term could be very painful, and that market-quotes (or NAV values on mutual funds) could still fall from here. Its probably best to think of high-yield as a low-beta equity investment rather than a bond investment. Go into it with the understanding that equity like gains and/or losses are possible, and size the trade accordingly.

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