With the sector now pricing in a recession, there is currently a great deal of value to be had from ...
With the sector now pricing in a recession, there is currently a great deal of value to be had from high-yield bonds. Even before the catastrophic events in the US, high-yield bonds were running at close to record levels of default.
As a consequence, while the risks have clearly increased, the potential uplift from firmer economic data and improving investor sentiment ' when it comes ' will really be something worth seeing.
Prior to the recent tragedy in the US, the worst possible news ' as far as we could image it then ' was already priced into the bond market. Given the improvement in economic data that we had identified, we were expecting defaults to fall going forward and for conditions to once more favour the bond market.
Inevitably, some sectors are now more exposed than others. Chief among these are obviously the airline and insurance sectors although secondary casualties are also mounting among hotel and travel operators.
Despite the fact that the global slowdown has rapidly become more severe than we could have anticipated, aggressive interest rate cuts by the Federal Reserve, Bank of England and European Central Bank ought to have the desired result of improving economic conditions and so ease default fears.
In the meantime, the slowdown has produced a sharp split in the high-yield sector, with defensive industrials on one side and the troubled telecom sector on the other.
In the first half of 2001, the industrial index rose by 10.9% compared to a 15.3% slump in the media and telecoms sector. Nevertheless, telecoms still account for half the index, down from 60% at the start of the year. Having been underweight in the sector, we quickly reduced weightings further in favour of industrial bonds while positively targeting the US bond market, which has maintained an enviable level of market liquidity. This has been reflected in the marked outperformance of US bonds over their European counterparts over the past three to six months. Normally European and US bonds move broadly in line, so either US bonds are expensive or European bonds are cheap ' we believe the latter to be the case.
The continued cuts in interest rates have already benefited investment grade funds, especially those with strong positions in shorter dated issues.
However, in light of recent events it will be some time before these lower interest rates begin to filter through to the improved economic growth and corporate cashflow required to improve the high-yield outlook.
Like any fund manager facing a market slump, we're forced to look at the market in terms of the value that is still locked inside while not committing ourselves to calling the bottom of the market. This, inevitably, can lessen the value of the message. It's worth remembering though that as the market heads for a new peak in default rates that, historically, the peak itself has always been a lagging indicator. This means that the best time to invest has always been before default rates find their final plateau.
High-yielding bonds on low valuations.
Economic outlook to boost confidence.
Peak in default rates is a lagging indicator.
Default forecasts have been reprised upwards.
Zero earnings visibility in wake of US attacks.
Threat to telecom, airline and insurance sectors.
James Foster is director of credit strategy and research at RSA Investments
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