"There are other possible explanations as to why the spreads have gone to 800 without the default rates going to 5% or 9% as they did in past cycles when the spreads were at this level," says Martin Fridson, a CEO at research firm FridsonVision. "Why is it at this level? The optimistic idea is that people have lost their minds, and when they come to their senses, the spreads will contract and prices will go up, and this will have turned out to be a great buying opportunity.
"But the other possible explanation is that the spreads reflect not only default risk but the comparative illiquidity of high-yield bonds next to Treasurys," Fridson continues. "The spread exceeds pure default losses, so what that tells you is not that the market is overvalued, which [by itself] is a meaningless statement. What it shows you is that investors demand a premium for the fact that they can't always get a bid for their speculative-grade bonds."
Fridson also points out a couple of other factors working against high-yield companies: Some data suggests that the real pinch in consumer spending hasn't been felt yet, since residual home equity loans and refinancings kept putting money in people's hands in the fourth quarter. Future quarters might show the real carnage. Furthermore, he says, the kinds of large companies that benefit from a cheaper dollar, i.e., the ones selling lots of goods overseas, are not vastly represented in the high-yield market.
One portfolio manager who thinks that high-yield looks a lot more attractive right now than the market acknowledges is Rachel Golder, the co-head of the high-yield effort at Goldman Sachs Asset Management. Golder agrees that defaults will rise, but thinks the peak in defaults will come much later, perhaps in 2009 and 2010, for a few reasons. One is that lighter covenants in the last few years will give lenders fewer reasons to withdraw their liquidity and send high-yield companies into default limbo.
"Until the music stopped in the middle of 2007," says Golder, "you had such generous liquidity terms that most players in the high-yield market had really filled their coffers with the liquidity they needed to operate for the foreseeable future. And ironically, one of the benefits that high-yield has-compared to either the investment grade market or any number of the other markets that are suffering stress right now-is a recognition that sometimes the capital markets go illiquid and there is a need to lock in medium- to long-term liquidity."
In other words, they may have battened down the hatches for bad weather already.
Drilling Down The Numbers
If the other factors goosing the market-specifically its illiquidity, volatility, uncertainty and indigestion-have you going for your Maalox, then consider the numbers that Golder has tried to tease out that show a bit of rationality in the current pricing of bonds.
As of March 24, the yield on the market was 10.75%, she points out. The recovery on defaulted assets has varied, but Golder thinks that the most recent level of 75 cents on the dollar is atypical and will likely fall back down to normalized levels of about 40 to 50 cents on the dollar. So assuming that there is a 5% default rate in 2008, as Moody's does, and 50% default losses, she figures there would be a 2.5% loss from defaults on a portfolio, clipped from the current 10.75% yield, which would bring it back down to an 8.25% level. This still outpaces Treasurys-offering about 6% excess return above the current level.
"So the question is, if you're not getting compensated for default losses, what are you being compensated for?" Golder asks. "First is the risk of further spread widening [which means] further principal erosion basically driven by price declines [due to] increased risk aversion in the market. And you know it's been an observation that it takes about 4% of loss to crystallize 100 basis points of spread widening-so if we're at about 800 basis points of spread and we felt that the market was going to widen by 100 basis points between now and the rest of the year, that would effectively cost your portfolio between 3% and 4%. So one of the things you could say in looking at that 6% of excess in return is: If you expected the market to widen by an extra 100 basis points, that would take 4% out of that expected return, but you'd still have an extra 200 basis points over your Treasury yield. So what is that for? It's basically for illiquidity and volatility; the uncertainty of all of these things; and the fact that you still have a market that remains quite frozen."
Adding all that up, she says that, at the moment, she thinks investors are indeed getting paid for the risk of default and spread-widening and volatility and illiquidity in the high-yield market.