Sunday, February 22, 2009 5 comments

Moody's predicts junk bond defaults hitting 16% by end of 3rd quarter

I'm still thinking of investing in high yield bonds. I'm not sure if I can do it in an affordable manner (brokers seem to require very high minimum investment and chart very high commissions--do note that I'm only talking about attractive illiquid bonds.) My thinking is that the credit markets may lock up again when governmenats nationalize banks and bondholders end up with losses. I'm thinking that is a good time to buy. But this is pure speculation and I may be missing out on an opportunity (yields have fallen significantly from December.)

Research Recap summarizes a report from Moody's stating that it expects a 16.4% default rate for junk bonds by November 2009, compared to 4.4% in 2008 and 1% in 2007. That's a huge jump and it goes to show why one should not draw much conclusion from the 2004-2007 time period. In fact, it is outright dangerous to use a chart like the one shown on that blog entry, and look back a few years in order to gauge valuation. Risk premium was so low a few years ago that I would consider that chart completely useless. I would want to take that chart back to the 1930's or if not possible, at least the early 80's and pick up the 1982 recession.

Moody's also says that $190 billion of speculative bonds need to be rolled over in the next 3 years. This doesn't seem as bad as the situation in Europe (although I'm not sure how much of the European bond threat is from speculative vs investment-grade) but it is still a big risk.

Canada's Financial Post also had a story a week ago covering the high yield bond environment:

The Merrill Lynch High Yield Constrained index is yielding 17.9% annually, up from a 52-week low of 9.87% in 2008. The index was priced for outright disaster back in December when it hit a high of 24.9% before spreads came in slightly. Yields have eased from white-knuckled induced highs but risks are clearly elevated, to put it mildly.

The simple math says that an 18% yield on an index of high-yield credits is easy money. A 16% default rate and 50% historical recovery of assets on those defaults translates to an 8% loss of capital this year and plenty of room for profits.

"We really don't know how high default rates will get," says Ben Cheng, veteran portfolio manager and President, Aston Hill Financial.

"Moody's default prediction is a best guess, but at the end of the day maybe default rates get to 20% or 25%," says Cheng.

One problem with the simple math is that historical rates of return have misled investors into complacency leading into this crisis. Critical analysis suggests that recovery rates in default situations will be much lower than in the past. If the typical creditor recovered 50% to 60% of assets in the past, those numbers could fall closer to 20% on current defaults.

There are two reasons why recovery rates will be lower than in the past. The first is that companies issued bonds with very light covenants at the expense of bondholders who invested with a herd mentality. Worrying about default protection seemed frivolous to bond investors only too happy to collect record low coupons.

The second reason is that defaulting companies have less access to capital needed for creditor protection. The cold calculus is that liquidations will be higher and creditor recoveries lower.

I have said this several times before but it's worth reiterating two points. Although yields are high, raw yields are still not extremely high. Analysts who keep referring to the opportunity being better than the during the Great Depression are only looking at spreads (against US Treasuries.) The spreads are very wide and higher than during the Great Depression (the junk bond market wasn't large and didn't really exist back then so analysts just use a rough comparison.) If you are an amateur investor, all you care about is the actual yield. The spread is very high but it is possible that US Treasury yields are too low (I don't buy this view but many think that US Treasuries are in a bubble.)

Secondly, as the article alludes to, recovery rates are likely to be lower so we need higher yields to compensate for the risk. Liquidating in this economic environment is going to be a disaster for creditors, with assets being sold at fire-sale prices.

The article finishes off by suggesting the type of bond that is attractive:

Take the Opti Canada Inc. high yield credits paying an 8.25% coupon maturing in 2014. Hedge funds were forced sellers of these bonds earlier this year, says Cheng, and the bonds are undervalued based on his analysis. The company, a joint venture partner with Nexen in the Long Lake oil sands deposit, recently sold 15% of its stake to Nexen for $735-million in cash to pay down debt.

With that cash, the Opti bonds, trading at 50¢ on the dollar, are attractive, says Cheng. Bondholders will be "made whole" come 2014 promising a current yield to maturity of 25%.

I think bonds like the (Canadian) OPTI bond suggested above is the ideal one to consider buying. Even though I'm bearish on commodities, I think bonds of commodity companies are attractive. A lot of commodity companies are beaten down and have assets worth owning. Even if these companies go bankrupt, bondholders may end up owning the company if it can be successfully restructured. Remember how Martin Whitman's best investment of all time is Nabors Industries, an oil&gas driller if I remember correctly, that went bankrupt after the commodity bust in the early 80's. Whitman is an expert and played an activist role in that but I'm just using that to illustrate a backup plan in case the company goes bankrupt.

Stocks vs Bonds

One of the risks with bonds is the opportunity cost. In this case, I am primarily referring to the cost of owning bonds as opposed to stocks. There is a very high opportunity cost right now for buying bonds. There are many companies trading with non-cyclical P/Es between 8 and 12. If it's a P/E of 10, that's an earnings yield of 10% with additional upside. Is it really worth owning a bond that has a fixed upside of say 15%?

For example, I had been looking at Sears (SHLD) bonds for a while. You may be able to find a bond with a yield of around 20% with a yield to maturity of possibly 30%. Well, given how the stock has sold off so much and may drop further, the stock starts becoming more and more attractive (assuming bankruptcy risk stays the same.) It's really hard to tell but Sears may have a normalized earnings yield of 25% (assuming its business doesn't completely collapse.) You can see how it's a tricky decision if one were to consider Sears bonds. Do you go for the, say, 30% yield to maturity in a bond or do you go with the stock with, possibly, 25% earnings yield (which will likely increase over time)?


5 Response to Moody's predicts junk bond defaults hitting 16% by end of 3rd quarter

Jae Jun
February 23, 2009 at 2:28 AM

Interesting. I'm trying to find high yield bonds myself but I dont know enough to have any conviction with purchases.
Sears sounds interesting and since I'm in the US, it would probably work out better for me than you as you mentioned in your way earlier posts.

February 23, 2009 at 10:10 AM

I'm kind of not sure if I know what I'm doing when it comes to bonds. On top of finding the right one and understanding them (unlike stocks each bond offering may have different rights and the like,) it is not a transparent market and hard for small investors to figure out what is happening. If I buy bonds, it'll likely be with a buy until maturity strategy.
If stocks keep dropping, they become more attractive so we'll see how things transpire...

February 23, 2009 at 10:24 AM

This comment was by me...

February 25, 2009 at 10:06 PM

I've been in and out of EFR as it is mainly hy bank loans with professional management. sAlternative is HYG or JNK but I prefer being higher in the capital structure for now.
Good luck.

February 26, 2009 at 10:14 AM

Thanks for the collateralized loan suggestion. I may look at it in the future but I don't find them that attractive. Quickly looking at EFR, it seems to yield 10% and seems to mostly hold BBB or lower. As for the professional management, it's hard for me to say who is a good manager and who isn't.
It's still worth contemplating but I'm not sure how one would pick the correct fund...

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