The first quarter of 2008 was hard on a lot of people, but especially on high-yield investors, whose junk bonds got thoroughly trashed.
All high-yield bond funds sank in the first quarter, with some yields climbing from 7% to 10% as investors fled to the redoubts of safer fixed-income investments. Merrill Lynch's high-yield index lost $41.6 billion in market value between December 31 and March 28. The average high-yield fund fell by 3.46% in that period, according to Morningstar Inc. in Chicago. Those who had traveled down the risk band got hit hardest-funds with larger concentrations of bonds rated single-B got it worse than those with double-B's, but did better than triple-CCCs.

The devil seemed to have come to collect his due after several years of high-yield outperformance. With a recession looming, liquidity will be harder to come by following a period when lending standards were much too loose. It's a cruel circle of life in the credit markets, as the Lion King might say.
But look closer, the sector's defenders say, and there's a lot more to it than that and a lot more to like about high yield. For one thing, they say that the current slaughter of the lambs is less about the fundamentals of the high-yield bonds themselves and more about the strange story of the entire fixed-income market since last summer. Specifically, they depict high-yield as suffering collateral damage in the subprime mortgage mess. As bad mortgages were circulated through the system like a financial version of botulism last year and cooked into strange pies with names like CLOs and CDOs, the large financial institutions were unsure exactly how much bad debt was on their books, and risk became difficult to price in the bank loan market. As a result, lending stopped, and the giant Wall Street investment banks began slashing questionable debt with large write-offs.

Meanwhile, a huge number of leveraged buyout deals were waiting in the wings, funded with bank loans and high-yield bonds. The bank loans, suddenly not able to move, created a huge backlog of debt that was left sitting unpriced and unwanted on the docks with nobody to ship it to. With these senior secured bank loans repricing downward, the high-yield bonds underneath them in the capital structure got sandwiched down underneath, and their values tanked.

Thus, there's been a major selling off of fixed-income investments across the board. So it's been a bad time to be in junk. And thus, the contrarians ask: Is it a good time to be in junk?

That's because the spreads on junk bonds have skyrocketed this year, tripling since last June. As the Fed cut interest rates, the high-yield spread over Treasurys spent much of March bouncing around the robust 800 basis point mark (the option-adjusted spread of the Merrill Lynch U.S. High Yield Master II Index over Treasurys was at 794 as of March 28, according to Merrill Lynch, after reaching a whopping 862 basis points on March 17).                 Meanwhile, company default rates continued to hug the bottom of their historic levels-Standard & Poor's had the speculative-grade default rate at 1.22% in February-though there were a few notable rumblings of the big default deluge to come, notably the faltering of multinational Canadian printing company Quebecor World, which filed for bankruptcy protection in January. With defaults seemingly at bay, and some predicting they will stay that way for the first half of the year, some think a window of opportunity had opened. Yet investors stayed home, ignoring the massive fire sale on junk bonds, betting not so much on the sale as on the fire.

"If defaults increase, then spreads widen more," says Scott Berry, a senior analyst at Morningstar. "You could see a lot of that yield advantage disappear and disappear pretty quickly." Berry feels that the rising yields augur better junk bond returns when defaults are falling and the economy is improving-like they were in mid-2002-but that's not the situation right now. Defaults have nowhere to go but higher. The question is not if but when. And how fast.

Standard & Poor's said in a report that it expects the speculative-grade default rate to rise to 4.6% in the 12 months after March 14, stepping up from the 2007 levels that were near quarter-century lows-the increase stemming from weak economic activity. The worry is that highly leveraged companies are going to have trouble finding money to refinance when the lenders who got burned in 2007 become a lot more tightfisted in 2008 and 2009. Companies' liquidity will dry up. The credit safety valves will likely be breached. Defaults and bankruptcies will follow. Who wants to be in junk bonds when all that happens?

So the parlor room debate now is this: At what point does the extra juicy yield make up for this risk of more defaults? And has it been priced in already? If so, then the higher yield suggests that there's a buying opportunity.

According to Gary Rodmaker, a managing director of fixed-income and high-yield at Summit Investment Partners in Cincinnati, "When you look at the absolute peak in the last 20 years, 1990 was a peak at a little over a 1,000 basis point spread. In 2002 it was similar at 1,000 basis points. Those were the last two peaks. Look at 1990. The next year, high yield returned 39%, followed by 17% returns the year after that. And if you look at 2002, when the spreads were at their peak, the 2003 return was 28% and the following year it was 11%. So a bit of history: When you peak out in spreads, the following couple of years is a good time to invest." However, Rodmaker concedes that with spreads at 800 basis points, it might yet be too early.
Says Matt Eagan, a co-portfolio manager of the Loomis Sayles Bond Fund, says that the interesting thing is, when you dig down through the bank loans sitting on top of the high-yield supply, there is not as much leverage and not a lot of issuance in the high-yield market. "So there's a lot of seasoned issuers in our market that are not having extreme credit problems that you might have seen during previous credit cycles." Relative to Treasurys, which he thinks could suffer from overvaluation issues, junk bonds will in the long-term offer an attractive relative return, though not a double-digit monster return.

There are skeptics who point out that the default rate is going to be even higher, however, if, say, the rate in the early part of 2008 were annualized. As of March 14, 12 companies had defaulted, bringing the total debt affected to $9.6 billion, according to Standard & Poor's. That trumps the entire $8.1 billion of defaulted debt seen in all of 2007.
A few giant bankruptcies can trigger a huge spike in default rates. Skeptics also point out that the current yields might be factoring in something other than default risk. And if the defaults haven't been factored into the price yet, then watch out! The current yield advantage could be wiped out by capital losses if the spreads spike again.