On the Fritz

Giving something back

Few utterances are as unconvincing as politicians’ ritualistic avowals that their primary motive for seeking power is to “give something back”. These statements are about as credible as it would be for high-yield investors to pretend that they enjoyed giving back 350-plus basis points of total return recently.

At 17.88% the Merrill Lynch High Yield Index’s return for the first half of 2003 represented a well-above-average year’s performance. Marketers prayed that the non-investment grade sector would at least earn the coupon through December 31. If so, it would go far toward erasing the ignominy of the preceding five years’ cumulative 2.64% return.

Alas, a sudden outflow of capital from the sector set back those hopes. During the first week of August, according to AMG Data Services, a record $2.56 billion exited the high-yield mutual funds. By August 15, the high-yield index’s year-to-date return had crumbled to 14.29%.

The only consolation was that holders of ‘risk-free’ 10-year US Treasuries fared much worse. Their return measured -2.52% for the first seven-and-a-half months of 2003. In fact, the non-investment grade sector’s retrenchment was largely attributable to the Treasuries’ extraordinary 100 basis point yield increase between June 30 and August 15. The high-yield risk premium (spread versus Treasuries) actually declined a bit. It was a case, however, of the ebbing tide lowering all ships. Speculative-grade debt, along with other fixed-income sectors far more sensitive to fluctuations in government bond yields, went underwater for a patch.

Notwithstanding the second half’s rough start, prospects for salvaging a decent year do not appear bleak, by any means. If Treasury rates stabilize, the fixed-income sector as a whole should fight its way back to positive returns. On the other hand, let us suppose that Treasury rates rise somewhat further in response to a rebounding United States economy. That will not be entirely bad news for holders of high-yield issues. According to research by the Federal Reserve Bank of New York, default rates generally ratchet down to a lower level when gross domestic product growth climbs out of the 1.5% to 2.0% zone. Consensus forecasts put second-half GDP growth comfortably above that threshold.

Already, Moody’s trailing 12-month default rate has fallen to 5.8% from a cyclical peak of 10.7% in January 2002. A further decline will probably be facilitated by the diminished aversion of banks to rolling over maturing debts of companies that although struggling, appear viable. Anecdotal evidence of increased forbearance was corroborated by the Federal Reserve’s August survey of senior loan officers.

None of this implies that lower-rated corporations can currently sell unlimited amounts of debt to undiscriminating investors. Recently several companies, including high-yield stalwart Charter Communications, canceled proposed offerings. Sticking to the standard script, the chief financial officers cited deteriorating market conditions.

Even as their deals were unraveling, however, investors happily bought other new issues that they preferred from the standpoint of credit quality or covenants. In short, portfolio managers still have cash to invest, but are more particular about where they invest it than in May and June.

If managers stick to their more stringent quality standards, their days of giving something back may be over for a while. Instead, they can focus on taking back the returns that they surrendered in July and early August.

Martin Fridson is a veteran of high-yield analysis and founder of FridsonVision, a high-yield research firm (www.leverageworld.com).

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