J.P. Morgan's Acciavatti: junk still "best house in a bad neighborhood"

By Paul Deckelman

New York, June 12 - If the financial markets were like the world of real state, Junkbondland "remains the best house in a bad neighborhood," a top J.P. Morgan & Co. fixed-income strategist said Wednesday - even though that "neighborhood," in his view "looks like it's getting worse and worse every day."

Peter D. Acciavatti, the big investment bank's head of high-yield credit research and strategy, told participants at the New York Society of Security Analysts' 23rd annual High Yield Bond Conference that up until about mid-May, high yield had been enjoying "what appeared to be a surprisingly strong start to the year, rolling up a nearly 6% cumulative return while notching an all-time record-low yield, which Morgan calculated at 5.24% according to its global high-yield index.

"Quite a difference the past month has made," he said, with no small amount of understatement, noting a 100 basis-point widening out in junk bond yields through the first week in June and about another 30 bps of widening in just the past week.

Fed fears roil market

The catalyst for that marked deterioration was the news that the Federal Reserve was considering a tapering off of its established expansive monetary policy, which the central bank has pursued over the last several years with the goal of assisting the United States and global economy by maintaining ample liquidity and keeping interest rates at historic lows.

But in explaining the changes that junk and other financial markets have seen over the past month and projecting likely developments going forward, Acciavatti took pains to emphasize that the idea of the Fed sharply throttling back on its current strategy of purchasing some $85 billion of securities a month to maintain plentiful liquidity, or even ending it all together, as some observers have speculated, is, at this point, just that - an idea, rather than concrete reality.

"The Fed has sort floated a trial balloon, to see how the markets would react - and I would stress that. It's a trial balloon."

He opined that "the Fed is happy with how much the Treasury market has reacted," with the yield on the benchmark 10-year issue rising from about 1.6% to around 2.2%, and speculated that the central bank was probably also "happy with having taken a little bit of the froth off of high yield as well as equities."

But he said that he doubts whether the Fed would want Treasury yields to move much higher, "considering that mortgage rates have also moved out considerably [over the past several weeks] - and that's certainly one of the bright spots with regard to the economy."

He does not believe that the economy "so far has shown enough evidence or signs of strength to suggest that the Treasury market should back up substantially," or that the Fed is likely to begin tapering in the near term. J.P. Morgan's economists think that any such tapering off won't start before the central bank's December policy meeting "if not early next year."

He said that the employment data released last Friday by the Labor Department, showing the addition of 175,000 new non-farm jobs in May, with the official jobless rate rising by 1/10 of a percentage point to 7.6%, "was [not] necessarily strong enough to suggest that it's clear evidence that [any planned tapering off by the Fed] is being pulled forward."

Acciavatti told the conference attendees that because of this, the 10-year Treasury yield is probably going to start to stabilize near current levels - and that, in turn means that after a little bit of a lag, investors are likely to see "some stability here in high yield. Then eventually, we expect yields to start to grind tighter, as well as prices moving higher."

Junk still has relative value

He noted that while junk bonds and leveraged loans have come well off the highs they hit in early May - a 5.90% year-to-date return for junk and 3.06% for loans - both asset classes continue to outperform other fixed-income investment vehicles, including 10-year Treasuries, high-grade corporate bonds and emerging market debt, all of which, he said, were "much, much worse. As of June 5, according to J.P. Morgan's calculations, junk was still showing a 3.28% cumulative return for 2013 and loans were ahead by 2.76%, but corporates were down 0.51% on the year, Treasuries lagged by 1.53% and EM bonds had fallen by 4.14% for the year, with the latter's swoon "somewhat of a surprise for me."

While acknowledging that it was disappointing to see the past month's sharp selloff, "if you woke up, not knowing the market was up and down and you simply arrived here in June and saw the market was up 3%, you'd say that was about right."

J.P. Morgan was among those forecasting at the beginning of the year that junk would see a return for 2013 of between 7% and 8%, after having notched a 16.2% rise for 2012, and "we still believe we're going to get to that 7% or 8% for the year. I still believe that once the 10-year stabilizes in this kind of low 2% range, which I do believe will happen, eventually you're going to get money coming back into retail funds."

Those funds - which saw outflows of nearly $875 million in the week ended May 29 and a massive record $4.6 billion for the period ended last Wednesday, according to AMG Data Services - "have really been the only source of outflows [from overall junk market liquidity] that we could tell - it's been the driver of behind the [market's] weakness."

At the same time that high yield has seen large outflows, the market for leveraged loans "has been on fire," seeing $1 billion of inflows to mutual funds in the week ended last Wednesday.

However, Acciavatti was cautious about drawing a cause-and-effect conclusion - that money flowing out of high yield was necessarily migrating over to the loan market as part of some kind of permanent reallocation by investors.

While acknowledging that "it certainly seemed like that" earlier in the year, when fund flows into high yield were modest, aggregating a couple of billion dollars total, while the loan funds were knocking down an average of about $1 billion a week, the Morgan research chief noted that even with last week's huge cash hemorrhage from the junk funds, the amount of money coming into loans did not change significantly, leading him to theorize that the formerly junk money "was probably going to cash."

At the same time that his shop is reiterating its previous forecast of a 7% to 8% return for junk, it also reconfirmed its projection that leveraged loans, which returned 9.7% in 2012, would likely come in with returns in the 5% to 6% area.

While the robust loan market is attractive, Acciavatti said that "relative value, I still think, points to high yield."

He noted "a perception that the loan market is substantially better off than high yield," a stance which he calls "a little misleading."

In junk, he said, "you have a coupon that's almost 200 basis points more than the average coupon that you'll find in the loan market. So you'd have to expect a pretty large increase in [interest] rates year after year after year to simply offset that."

"If you just look at the coupon for the rest of the year, that's going to get us about 6½%. To say that the market will be up a point, or two or three, I don't think is that crazy, so we're basically saying that that the yield ends the year somewhere in the 5½% to 6% range."

He said that it is unlikely for yields to drop back down to around 5%, "but 5½% to 6%, to my mind looks about right, in particular given to where spreads are trading versus default rates."

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