November 21, 2008
UNSAFE AT ANY YIELD?
This year will be remembered for many things, most of them negative, brutish and just plain ugly. But 2008 will likely to go into the history books for other reasons, too, including a year that extended extraordinary gifts to strategic-minded investors. No less extraordinary will be the dearth of investors willing or able to accept the gifts from the financial gods.
So it goes in the money game. When prospective returns--long-run prospective returns--are thin, the crowd can't get enough. At the other extreme, when risk premia is soaring, Mr. Market finds few takers. All the more so when fears of depression are swirling about.
Consider the chart below, which is but one example of the astonishing repricing of risk now underway. The recent spread in junk bonds over Treasuries is currently at levels last seen, well, almost never, at least since the modern notion of high yield bonds as an asset class was minted in the 1980s. Today, the asset class can be had at a yield spread of nearly 1,700 basis points over a 10-year Treasury yield. For reasons that need no explanation, there are few takers, which is one factor for why the spread's so high. By comparison, in June 2007, the spread was compressed at one point to less than 260 basis points, a level that investors were happily accepting.
There are, of course, many reasons for shunning such rich spreads, just as there were many reasons for accepting the narrow spreads in June 2007. Indeed, juicy yields invariably come prepackaged with economic contraction and higher rates of defaults in the junk bond universe. They don't call 'em junk for nothing.
Are yields now sufficiently high to compensate for the higher level of defaults that are surely coming? No one really knows, although that doesn't stop anyone from considering the broader context. On that note, junk bond guru Martin Fridson of Fridson Investment Advisors in New York told Bloomberg News on Wednesday: "Either the [high-yield bond] market is right and expecting a default rate considerably higher than it was in the Great Depression, or we have such profound dislocations and selling pressures going on that it really is creating extraordinary fundamental value.''
Yes, the spread may go higher still, perhaps much higher. At some point it'll stop going up and it's a near certainty that almost no one will be buying at the apex. Indeed, few are buying now, and the buyers will surely dwindle further in the weeks and months ahead. That's not entirely illogical, since some of us like to get a decent sleep each night.
This much, however, is clear: Several years from now, when we all look back on 2008, many of us will promise to buy if junk spreads ever go that high again. The lesson being: great bargains only look compelling in a rear-view mirror, a.k.a, talk is cheap.
Posted by jp at November 21, 2008 10:28 AM
Maybe if we disaggregate the data we can answer the question. If high spreads are sustained, then most or all of the junk rated companies that depend on refinancing are likely to capitulate in one way or another. Fitch did an analysis a while back showing that an unprecedented number of companies were of this junkiest grade. So, a focus on security selection (including busted converts) instead of broad asset class exposure may solve the dilemma for real money investors with longer horizons.
Posted by: PWM at November 22, 2008 2:40 AM