The coming year has the potential to be a big one for the high-yield market as market players project as much as $84 billion in debt being downgraded to junk status. The newly downgraded names, coupled with peaking Federal Reserve rates, may help get the bad taste of 2005 out of high-yield investors' mouths.
"We should have a pretty good resurgence in high-yield in the coming year with peak short-term yields and a 4.50 to neutral rate policy; people will take more credit risk," stated Matthew Smith, v.p. and portfolio manager for enhanced fixed income at Smith Affiliated Capital. "This year alone you have had $514 billion of debt downgraded globally as opposed to only $114 billion upgraded. Upgrades are at two- and- a half year lows. There is $84 billion in potential fallen angels just about ready to hit, all of which could have relatively good value."
Smith stated that investors must still be careful and look at each credit even when the surface value looks good. "Take General Motors, for example. They have less than fair value. They have a lot of liabilities like underfunded pensions, and that kind of thing is going to go on the books; it will lead to further downgrades," he said. Smith noted that Ford Motor, with no legacy or pension problems and solid books, has far more value and would be a better investment.
John Lonski, chief economist at Moody's Investors Service, echoed Smith's thoughts. He feels that high-yield debt could return as much as 8% in 2006. That figure is around five times the number that was returned in 2005. Junk bonds only returned around 2%, making it the worst year for high yield since 2002. Lonski also believes that spreads could be around 3.75-4.25 over the course of the next 6-12 months. He adds that defaults in 2006 could reach as high as 3.5%. A report by Bear Stearns places the figure slightly higher, with a high end of 3.75%.
There is also a strong sense that a fair amount of high-yield bonds may become distressed debt in 2006 and the defaults may come on issuance that is a lot more recent than many may think. Katalin Kutasi, portfolio manager at Keller DiLeo Cohen & Co., observes that many of the defaults in 2005 were issued near the end of 2003. "We're starting to see defaults a lot sooner than the three-year aging period." If this trend holds, many defaults in 2006 may come from issuance from early to mid 2004.
Smith also sees the widening of corporate paper. "With the U.S.Treasury coming out with 30-year, non- call paper, I think that you are going to see a lot of people move out of high yield callable corporates and into this 30-year bullet paper. This could be a major factor and trend as we head into 2006," Smith concluded.