Depressed high yield, investment grade prices, stabilizing credit markets bring opportunities, buysider says

By Kenneth Lim

Boston, April 1 - High yield and investment grade opportunities are beginning to appear as the credit markets show signs of functioning again amid depressed prices, said Western Asset Management portfolio manager Michael Buchanan.

"We think there's a lot of opportunities in risk assets now, whether it's investment grade or high yield," Buchanan said in a conference call.

The high-yield market dropped a little over 26% in 2008, making it "by far the worst year on record for high yields," Buchanan said.

Relatively defensive sectors, such as consumer staples and healthcare, did better in 2008. Higher-rated credits also did better amid a flight to quality.

"Clearly investors were taking some comfort in the higher quality part of the high-yield market, even though those credits didn't escape unscathed," Buchanan said.

On the other hand, cyclicals such as technology, basic industrials and autos faced tremendous pressure. New issuance also slowed to a trickle, with only about $50 billion in new high-yield issues in 2008 compared to almost $140 billion in 2007.

"Obviously liquidity in the market was down substantially," Buchanan said.

Defaults also rose from all-time lows at the end of 2007, at a trailing 12-month rate of about 1%, to about 4.4% at the end of 2008.

Multilayered problems

Buchanan noted three reasons that the markets came under such pressure in 2008.

The first was that investors were increasingly pessimistic about the U.S. economy.

"I think there was more deterioration when you look at housing, when you look at unemployment, when you look at consumer confidence," he said.

That pessimism was exacerbated by what was going on in the financial sector, Buchanan said.

"What happened not only with the stocks...but even the bonds of these institutions were down substantially, and there was clearly a crisis of confidence in financials," he said.

But the credit markets may be overly depressed based on what the prices are implying, Buchanan said. He pointed to yield levels in the junk sector, where the average bond is currently trading with a yield to worst of about 19.25% and a price of just a little over 60 cents to the dollar.

"Clearly the market is pricing in a default scenario that is going to worse from where we are," he said.

Buchanan reckons that, based on Western Asset's models and analysis, the market is pricing in an ongoing default rate of about 18.5% over the next five years, implying a cumulative default rate of 63%. During the Great Depression, the cumulative default rate was only about 45%.

"In a historical context, that looks to be a scenario, an environment that we've never seen before...our belief is that while certainly defaults are going to be higher, we don't think they're going to get to those levels," he said.

Bargain hunting

Those depressed values suggest that there opportunities in risk assets at the moment, he said.

Buchanan is upbeat about the credit markets, which he said are beginning to stabilize. New issuance, which started with high-quality investment-grade names, has begun to move down the credit scale, suggesting that risk appetites are gradually coming back to the market.

Western Asset is looking at higher-beta names and is slightly overweight credit that is rated CCC and B, he added. That strategy did not work well in 2008, but in March there were signs that the strategy is starting to work, Buchanan said.

"We think there's been a lot of good credits within those sectors, those two rating categories, that were unduly punished," Buchanan said.

In terms of industries, Western Asset is overweight defensive sectors such as health care and wireless, and underweight less recession-resistant segments such as consumer cyclicals, technology and, until recently, gaming.

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