On the Fritz

Waiting for the Big One

Like the residents of a city built on a fault line, many high-yield bond managers are currently waiting for the Big One.

By way of background, the high-yield sector’s risk premium was chopped in half during the first 11 months of 2003. On November 30, the spread between the Merrill Lynch High Yield Master Index and 10-year Treasuries stood at 410bp, down from 820bp at the end of 2002. Portfolio managers enjoyed the resulting 25% total return. As the market roared further ahead in early December, however, they became increasingly worried that the non-investment grade sector was setting itself up for a nasty fall.

Sooner or later, the fears of a big correction are almost certain to be fulfilled. Let us define ‘big’ as a widening in the spread versus Treasuries of 100bp or more over a three-month period. Since the inception of Merrill Lynch’s index in 1986, a calamity of that magnitude has occurred 10 times, or about one out of every seven quarters. The most recent instance was six quarters ago, in the second quarter of 2002. Some investors may conclude that a quake is just about due.

In reality, the high-yield market’s large corrections have been spaced irregularly over the years. Of the 10 100bp-plus quarterly increases in the spread, for example, five occurred within an 11-quarter span during 2000–2002. On the other hand, not a single such event occurred during a 31-quarter span between 1990 and 1998. For the most part, then, the high-yield market has either been in a period of calm or in a jumpy period. Only occasionally have one-off shocks been observed, such as the 1990 Iraqi invasion of Kuwait and the 1998 Long-Term Capital Management crisis.

At the moment, the case for placing 2004 in the jumpy category rests mainly on the prospect of a significant rise in interest rates. There is certainly precedent for such a development. Right in the middle of the last long period of calm, the United States underwent one of the worst interest rate episodes on record. In 1994, Alan Greenspan launched a preemptive strike against renewed inflation. The Fed Funds rate soared by 2.5 percentage points and 10-year Treasury yields jumped by more than 200bp. High-yield bonds limped in with a -1.03% total return, the only solace being that 10-year Treasuries fared much worse, at -8.29%.

Few forecasters envisage a scenario as dire as 1994’s in 2004. Of 59 economists surveyed by Bloomberg News, for example, only one predicts that Fed Funds will rise by more than 1.5 percentage points. Only two foresee a rise of more than 125bp in 10-year Treasury rates.

Granted, 2000’s two 100bp-plus expansions of the spread versus Treasuries occurred against a backdrop of a Fed Funds increase of only 1.25 percentage points. In the same year, though, Moody’s default rate (percentage of issuers basis) rose by a full percentage point. Currently, by contrast, Moody’s is projecting a year-on-year decline in default rates.

Naturally, the danger of a shock like the Kuwait invasion is always present. Moreover, the risk of a significant correction within the next few months appears high, based on current valuations. Judging by history, however, 2004 does not look like the year of the Big One.

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

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