case for hg and hy 0301 (2016_01_25 03_57_23 utc)
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THE CASE FOR U.S. HIGH-GRADEAND HIGH YIELD CORPORATEDEBT IN 2001
We believe that high-grade and high yield corporate debt
securities will outperform most other fixed income sectors in 2001.
In a nutshell, here’s why:
� The liquidity environment is supportive.
� Risk-adjusted valuations are historically cheap
by several measures.
� Corporate capital spending is declining.
� Investor psychology has gotten used to the idea
of decelerating macroeconomic growth and is
better-prepared for bad news.
� Rising defaults in the high yield market suggest that
the timing for investment in high yield is favorable.
� Tolerance for risky assets is much greater than previously.
The CSAM U.S. Core Fixed Income Management Team
New York, March 30, 2001
T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 12
2 0 0 0 : T H E PA S T A S P R O L O G U E
Before we look forward, it’s instructive to briefly look back on
2000 to see how today’s market conditions took shape.
2000 was a year of historically unprecedented distress in U.S.
credit markets. [Note: by “distress,” we specifically mean
instances in which bond prices fell at least 15% in a short period
of time.] Selling activity was harsh, as investors fled credit sectors
in response to rising interest rates, extraordinary volatility in the
equity market, and anxiety about slowing macroeconomic growth
and its negative implications for borrowing costs and corporate
earnings. It was not uncommon for bond prices to plunge 40
points or so very quickly, based on even a hint of bad news. In
the high-grade universe, the bonds of numerous prominent
companies suffered such pain.
It’s safe to say that most large investors in high-grade debt
during 2000 were hit by “credit bombs” ( i.e., sudden shocks to
creditworthiness in the form of things like unexpected earnings
shortfalls and ratings downgrades) from these companies or
others. The result was selling whose snowballing impact on the
marketplace took on a life of its own: fear of credit bombs
turned into falling risk tolerance, which prompted further selling
to reduce overall risk
exposure, which created
a dramatic imbalance of
market liquidity in which
sellers rushed headlong
for the exits while buyers
nearly disappeared.
Year-end valuations
reflected the extreme
pessimism that pervaded investor sentiment. Option-adjusted yield
spreads for high-grade corporates versus U.S. Treasuries, for
example, were 190 basis points (bp) according to Lehman
Brothers, up from 111 bp at the end of 1999. Aggregate high
yield paper, in the form of the Credit Suisse First Boston
Domestic+ High Yield Index, traded at 950 bp over Treasuries,
compared to 554 bp a year earlier.
High-Grade and High Yield Spreads vs. Treasuries(in basis points, 1990-2000)
Y E A R - E N D 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0
High-grade * 151 107 88 84 78 60 53 64 118 111 190
High yield ** 1096 729 548 481 388 484 355 386 657 554 950
* Lehman Bros. option-adjusted spreads for aggregate high-grade ratings sectors ** CSFB Global HY Index for 1990-1998; CSFB Domestic+ HY Index for 1999-2000 Sources: Lehman Brothers, Credit Suisse First Boston
A year ofhistoricallyunprecedenteddistress in U.S.credit markets.
T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 1 3
2 0 0 1 : R E A D Y F O R TA K E - O F F
As we write late in the first quarter, we’re happy to say that the
marketplace has changed in ways that, in our opinion, bode very
favorably for the performance of U.S. high-grade and high yield
corporate debt. Essentially, the gloom and doom of 2000 sowed
seeds of appreciation that are already starting to bear fruit.
THE LIQUIDITY ENVIRONMENT IS SUPPORTIVE. Perhaps
the single most bullish development for the credit markets thus
far in 2001 has been the
Federal Reserve’s
aggressiveness in
promoting monetary
liquidity. The Fed
unexpectedly cut short-
term U.S. interest rates
by a half-point on January
3, and chopped additional half-points at its regularly scheduled
FOMC meetings on January 31 and March 20.
The positive significance of the Fed’s accommodative stance for
corporate debt is multi-faceted:
� Dealers’ short-term financing costs for positions in corporate
bonds have become attractively lower, which helps to facilitate
trading activity.
� The yield curve has steepened, which serves to nudge
investors to buy longer-dated and higher-yielding debt.
� Borrowing costs have fallen, which reduces debt-service
obligations and means that funding is more readily available for
borrowers all along the credit spectrum.
� Prospects for U.S. macroeconomic growth in the second
quarter have improved, which should ultimately raise corporate
creditworthiness in general.
� Big buyers of corporate debt like insurance companies and
banks have more cash around to invest in bonds.
We agree with the consensus view that the Fed will probably cut
short-term rates again during the second quarter by a total of
100 bp. Our research indicates that corporates tend to
handsomely outperform in the periods surrounding Fed rate-cuts.
RISK-ADJUSTED VALUATIONS ARE HISTORICALLY CHEAP
BY SEVERAL MEASURES. Several metrics we utilize to
measure risk-adjusted
valuations for high-grade
and high yield corporates
unanimously indicate that
investors may currently be
much better-compensated
than usual for buying
bonds in these sectors. In
other words, corporates
are historically cheap. This
remains the case even after bonds have rallied so far in 2001.
� By the most standard metric, yield spreads, Lehman’s
Corporate Bond Index is trading at an average of nearly
200 bp higher than comparable Treasuries.
� Option-adjusted high-grade spreads (i.e., from Lehman) and
high yield spreads (i.e., via the Salomon Smith Barney
High-Yield Market Index) are at around 1.6 and 2.8 standard
deviations from their respective historical means.
� The break-even default rates for high-grade and high yield
(i.e., the average annual rates at which defaults would have
to compound in order for these sectors to underperform
Easier Fedmonetary policy is especially bullish.
High-grade and high yieldcorporates arehistoricallycheap.
T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 14
Treasuries over the next 10 years) are unprecedentedly high.
This suggests that the relative risk of owning high-grade and
high yield—that is, the likelihood of their underperforming
Treasuries—in the foreseeable future is low.
CORPORATE CAPITAL SPENDING IS DECLINING. A major
contributor to anxiety in the credit markets last year was the
massive levels of debt raised by companies to fund huge capital
projects, notably for telecommunications and technology
infrastructure. Telecom
and tech companies
themselves, moreover,
were forced to raise
capital (often via debt
issuance) to pay for the
high costs of new-
generation wireless
licenses and their corresponding equipment requirements.
Ratings on bonds of big-name and smaller companies alike were
slashed accordingly by ratings agencies.
The fallout from this situation was most acute in the high yield
market, in which fixed-line telecom companies returned –25.8%
(i.e., in the Credit Suisse First Boston Domestic+ High Yield
Index). This was not only the year’s worst performance among
high yield industry sectors, but also represented the most
negative change in return among high yield industry sectors
compared to 1999. The increase in spread-to-worst (i.e., the
spread between the lowest yield an investor can receive among
those corresponding to a bond’s potential maturities and that of a
comparable-maturity Treasury issue) versus 1999 for fixed-line
telecom companies, in addition, was the biggest such increase in
the high yield market.
Fortunately, we can say that “That was then, this is now,” and
now is starting to look a lot better than then. The simple
explanation is that so much was spent on infrastructure that,
broadly speaking, less is needed. This should be a boost to
creditworthiness both for telecom/tech issuers and the corporate
market as a whole. 2001 should prove to be the next phase—
i.e., one of healthy self-correction—in this boom-and-bust cycle.
INVESTOR PSYCHOLOGY HAS GOTTEN USED TO THE
IDEA OF DECELERATING MACROECONOMIC GROWTH AND
IS BETTER-PREPARED FOR BAD NEWS. Much of the activity
across asset classes and regions in 2000 was driven by a
gnawing uncertainty about the extent to which macroeconomic
growth, both in the U.S. and globally, was slowing down. The
pendulum of investor psychology swung 180 degrees from the
boundless euphoria of late 1999 to a deepening pessimism about
interest rates, corporate earnings, energy prices and inflation.
At this point, our sense is that psychology is far more in synch
with the potential for bad
macroeconomic news
than it was last year.
Movement in the equity
market is already
demonstrating that some
investors are willing to
stomach the weak data projected for the next couple of quarters
or so and, instead, look ahead to what they hope will be a
resurgence in growth a bit further down the road. Given the low
level to which corporate-bond valuations have fallen, this suggests
that the upside potential from this kind of psychological adjustment
could be substantial.
Lower capitalspending is good for creditworthiness.
Investors are more tolerant of bad news.
T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 1 5
RISING DEFAULTS IN THE HIGH YIELD MARKET SUGGEST
THAT THE TIMING FOR INVESTMENT IN HIGH YIELD IS
FAVORABLE. According to Moody’s Investors Service, the
default rate for issuers of U.S. speculative-grade debt securities
in 2000 was 6.82%, up
from 5.75% in 1999 and
the highest such rate
since the all-time high
of 10.57% in 1991.
[To put this in historical
perspective, 1991 was
the apex of the meltdown
that struck the high yield market due to a singularly painful
coincidence of macroeconomic recession, the demise of Drexel
Burnham Lambert and the Gulf War.]
Moody’s currently forecasts that this rate will rise sharply in 2001
and reach a new all-time high of nearly 11.00%. While this does
not sound like something to cheer about, we note that yield
spreads in the high yield market—and, therefore, investor
pessimism—tend to peak (and then start to narrow) months ahead
of a peak in actual default rates. If this historical pattern continues
to hold true, as we think it will, it means that the present could
turn out to be an unusually opportune time to be in high yield.
TOLERANCE FOR RISKY ASSETS IS MUCH GREATER THAN
PREVIOUSLY. The sum of the preceding factors we’ve cited in
this section is that investors are much more comfortable with
risky assets now than they were even a couple of months ago.
This has an impact on overall market sentiment that is impossible
to quantify, yet materially beneficial.
L E T ’ S N O T F O R G E TT H E R I S K S
Although our optimism about high-grade and high yield
corporates is great, we must not forget the meaningful sources of
risk out there that could push bond prices downward or, at the
very least, prevent them from rising much. We see the most
important sources of risk as the following:
THE MACROECONOMIC ENVIRONMENT DOESN’T
IMPROVE. The economy, of course, is the key to the outlook for
any asset class. If the state of the macroeconomic environment in
the next few months reaches any place along the range of
conditions that represent a lack of improvement (e.g.,
deceleration, stagflation, recession), then the critical mass of
Peak default rates have been good for high yield returns.
2000
1500
1000
500
0
-500
-1000
-1500
-2000
12
10
8
6
4
2
0
Default Rates Have Been Good For High Yield Returns
Source: Lehman Brothers, Moody’s
-775
1989
-515
1990
1660
1991
552
1992
671
1993
258
1994
57
1995
769
1996
343.6
1997
-775.6
1998
479
1999
-1825
2000
904
2001 Forecasts
Excess Return of High Yield (bps)
Moody’s HY Default Rate
2001
Exc
ess
Ret
urns
(bp
s)
Def
ault
Rat
e (%
)
T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 16
positives needed to drive upward appreciation simply won’t fall
into place. We’re most concerned in this context about the recent
plunge in consumer confidence, which tends to be an accurate
directional indicator of yield spreads.
EQUITIES CORRECT OR EXPERIENCE ADDITIONAL HARSH
VOLATILITY. Investors in corporate bonds pay close attention to
developments in the equity market, which are usually driven by
news about earnings or other events. Considering the battering
that equities absorbed in 2000, it’s thus hardly surprising that
high-grade issues underperformed and high yield was crushed.
Stocks have rallied and then fallen even more in 2001, as
investors have alternatingly celebrated the Fed’s aggressive
interest-rate cuts and then feared that it won’t feel compelled to
keep cutting as much as market participants would like. What this
tells us is that it’s not out of the question for equities to correct
some more, which could well be bad news for corporate bonds.
THE TELECOM SECTOR DOESN’T RECOVER. We’ve
described the big problems faced by the world’s leading telecom
operators, some of which (e.g., AT&T, British Telecom, Deutsche
Telekom) are among the largest issuers in the corporate debt
market. If these companies can’t make visible progress toward the
resolution of their problems fairly soon, it’s likely that their bonds
may be further downgraded, which would result in wider spreads.
The sheer size of AT&T and its colleagues in the market, then,
means that such widening would undoubtedly have a spillover
effect not only on bonds of other telecom-related companies, but
also the high-grade and high yield markets more generally.
THE LIGHTS GO OUT FOR CALIFORNIA UTILITIES.
Headlines have blared about the severe financial squeeze that
has gripped the major California electric utilities, Edison
International and PG&E Corp. (both of which are large debt
issuers), in the last few months. The situation is tense and may
well end up with either or both companies forced into bankruptcy.
If things get appreciably worse, it’s not unrealistic to project that it
could have harmful effects on the rest of the country in the form
of higher electricity prices, credit problems for related lenders and
deteriorating credit quality for affected municipal borrowers. Since
California accounts for around 13% of U.S. GDP, is the nation’s
largest state economy and the sixth-largest economy in the world,
a lights-out scenario there could spell plenty of trouble elsewhere.
HOW WE’RE POSITIONEDTO SUCCEED
We have positioned our Core Plus portfolios to benefit from the
outcome that we anticipate. Specifically:
� We are overweighting high-grade corporates vs. relevant
benchmarks and recently added to total high-grade exposure.
Our focus has been on buying the long-maturity debt of issuers
that underperformed the broad market in 2000 and have good
prospects for de-leveraging and steady operating performance.
� We are shifting high yield exposure down the credit continuum
to single-B names from BBs, in line with our belief that lower-
rated credits have the most upside potential because they’ve
taken the worst punishment.
� We are placing increased emphasis on diversification as a
means of reducing portfolio risk. This takes the form both of
more names within high-grade and high yield industry sectors,
and smaller position sizes per name.
In addition, we note that there is great dispersion among the
returns of individual issues. This indicates that security
selection—which has, historically, been among the primary
strengths of our management approach—should play a vital role
in manager performance.
The information presented is for informational purposes only. CSAM’s investment views may change at any time without notice. This report is not a
recommendation to buy or sell or a solicitation of an offer to buy or sell any securities or adopt any investment strategy. Readers are advised not to infer or
assume that any securities, companies, sectors or markets described will be profitable and past performance is no guarantee of future performance.
Companies, securities and/or markets listed herein are solely for illustrative purposes regarding economic trends and conditions or investment process and
may or may not be held by accounts managed by CSAM. Characteristics and performance of individual client accounts will vary. The information presented
has been prepared on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. No
assurances are provided regarding the reliability of such information. All opinions and views constitute judgments as of the date of writing, are subject to
change at any time without notice. Investing entails risks, including possible loss of principal. The use of tools does not guarantee investment performance.
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