BoA credit strategist recommends going further down credit ladder for yield boost

By Ronda Fears

Nashville, Oct. 28 - Banc of America Securities' top credit strategist Jeffrey Rosenberg said there's more opportunity for yield compression in the lower-rated credits so he suggests reaching farther down the credit spectrum for that exposure.

"The shifting of influence between credit and interest rate risk, and the constructive outlook on the economic recovery both support our recommendation to increase credit exposure by reaching down in the credit spectrum," Rosenberg said in a report Tuesday.

"The lower-rated names offer higher yield, exhibit the lowest interest rate sensitivity and tend to benefit the most as economic recovery takes off.

Crossover and high yield sectors show the most promise for further spread compression, he said, but there's still risk to consider.

"Actual and expected default rates continue to fall, lowering the floor on spreads while risk premiums in the high yield market still lag the decline in implied volatility," Rosenberg said.

"Interest rate risk in the high yield market, however, remains a concern for dedicated high yield portfolios (i.e. total return investors) as interest rate risk increases on the heels of declining credit risk."

The risk premium has contracted sharply over the past year, he said, but seems to be leveling off. The biggest wildcard is volatility, he noted.

"The high yield risk premium more than halved from 662 bps at the end of October 2002 to 271 bps observed on Sept. 30 of this year," Rosenberg said.

"The collapse in the risk premium, when viewed purely on a historical basis, appears to be approaching 'normal' or historical average levels. However, viewing the risk premium on this historical basis alone ignores changes in the macro- and microeconomic environment that influence the pricing of risk.

"Since stock price volatility reflects cash flow uncertainty and since option prices reflect the cost of hedging equity values in the future, volatility implied by the price of options measures default rate volatility on a forward looking basis. As a result, implied volatility measures expected default volatility, matching an expected default rate from our default rate forecast.

Implied volatility explains most of the variation in the high yield risk premium, he noted, and is the primary explanatory variable in rich/cheap relative value models for high yield.

"Since default risk uncertainty (i.e. implied volatility) has been falling along with default rates, the relative value model suggests that there is still room for further spread tightening in the high yield market," Rosenberg said.

As of Oct. 21, he said the model's projected non-CCC spread-to-worst is 120 bps lower than the actual market spread, pointing to a scenario of additional spread tightening.

"Note however that this relative value forecast implicitly assumes that the cheapness in the spread will collapse through spread tightening rather than volatility increasing," Rosenberg said.

"Generally, declines in implied volatility tend to precede declines in spreads. Hence, if the market behaves in a way consistent with past behavior spreads are more likely to collapse to the level suggested by implied volatility than the other way round. As a result, we still see relative attractiveness in the spreads offered in the high yield market."

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