Hancock's Evans: high defaults, low short-term rates are buying signal

By Paul A. Harris

St. Louis, Mo., Oct. 11 - Moody's Investors Service's upward revision of its forecast "cyclical peak" in the global corporate bond default rate on Sept. 24 continues to generate concern and debate among investors and analysts in the high yield market.

To Barry Evans, chief fixed income officer of the John Hancock Funds, high defaults represent a catalyst with regard to the high yield market. What's more, he believes, those defaults represent a risk that comes pre-factored into the current dynamics of the market.

During a recent conversation, Evans, for the sake of argument, selected the Chase Global High Yield Index (CGHYI), which, he said, was presently showing a yield 13.98%. Rounding that yield off to 14%, he laid out the following scenario:

"Let's hold the world constant," Evans said, constructing a hypothetical model, "no defaults, no changes in rates, no changes in spreads. A year from now if I invest in the CGHYI, I will have a 14% total return. That's pretty good.

"Now let's assume that the Fed is lowering rates and pushing $2 trillion of liquidity that's in money market funds into the system. The credit premium you get paid today for bearing the risk of high yield relative to Treasuries is about 10 percentage points. If the Fed is pushing liquidity into the system and the fiscal policy is lowering the risk of the system, it is reasonable to assume a year from today that the risk premium will be less."

Continuing his hypothetical scenario, Evans put forward the assumption that present circumstances - recession, high defaults, domestic uncertainty and war - might possibly inhibit that risk premium from settling back into its average of the past five years; rather, for the sake of argument, he assumed it would settle only halfway back to that average.

"In that case, the capital appreciation on the CGHYI would be something like 9%," he said. "So you would get, on your one-year horizon, your 14% yield, on top of your 9% capital appreciation. You're at a 23% horizon return, over one year. That's a good starting point.

"Let's assume, at the same time, that we get one of the worst default rates that we've seen since 1991: defaults go to 11%; losses go to 6% on that default rate. Let's subtract the 6% loss rate, and another percentage point or two for lost income, which you would use. If we take out 6%, plus another two for lost income - you can even actually make it another four - 10% from a 23% horizon return, you're still positive."

"That's what the market's missing right now," Evans insisted. "The market has already priced in a reasonably high default rate. If you were to say, 'What is the one good indicator that now is the time to buy high yield?' There are two things you want to look for: very high defaults and very low short-term rates, seeing that the Fed has pushed liquidity into the system. That's what you've got now.

"We're at that stage of the cycle where I suspect high yield is going to start doing better for the balance of the year, and it will start rallying. And we'll start seeing more and more headlines about companies filing for Chapter 11. But this is the stage of the cycle where you're supposed to start buying high yield, because the market will anticipate recovery."

End

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