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| Chris Towle |
Towle is partner, portfolio manager and director of high-yield and convertible securities at Lord Abbett in Jersey City, N.J. Lord Abbett has $8 billion in high-yield. With spreads as tight as they are, where do you see relative value in high yield?
I am still seeing some relative value. I think a lot of people's comments about tight spreads are compared to the recent past in years such as 2002 and 2003 and there's nowhere near the amount of value as there was then. It used to be "here's a discount company trading at 80," but the market has become much more fairly or fully priced. But I do still see some opportunity. The high-yield market is the last bastion of emotional-type investing. Every so often you hear about a company with a bad quarter trading down five points, so you have to react to emotional outbursts. You can take advantage those opportunities and take a long-term view. You can use analytical resources on a bottom-up basis and take a long term view in event-driven situations.
There are also still trading opportunities, decent relative values and some discount in industrials and chemicals, in names such as INVISTA and Crompton Corp. Both those securities have popped up. Industrials have good cash flow growth and have made balance sheet progress and will still do well in terms of earnings growth. Chemicals have benefited from a worldwide economic improvement over the last five years. There hasn't been a lot of capital expenditures in the chemical areas and utilization is raising, margins are improving dramatically and we should see decent profitability. Three months ago, I would have had a list of 10 names that would all go up. We don't have that right now.
Are you expecting spreads to widen?
The market is fully priced and you'll see some articles with a negative take on high-yield bonds. But if you look at high-yield spreads over the last 20 years, high-yield performance has been great. If you look at a spread chart, we've gone from 1,100 basis point spreads in September of 2002 to 375bps now that's the J.P. Morgan High Yield Index. The point I wanted to make is the same thing happened in 1991-1992 and spreads got as tight as 304bps in 1997. Spreads stayed in the 300-450bps over range and we can replicate that now. I expect them to stay in the 350-400 range with the average bond yielding 8%. You can sustain that through 2005.
Is high yield still an attractive asset class?
One of the biggest characteristics in the market right now is the shortage of yield. The Federal Reserve has tightened four times and money market funds are yielding 1 1/4%. Maybe a year from now they'll yield 1 3/4%. After 1 1/2% inflation and taxes, that's a negative real return on money market funds. There's $1.9 trillion in money market funds and $3.25 trillion in savings deposits--that's a ton of money on the sidelines. There's a shortage of yield in Europe and Japan, too. People need income and there's no income anywhere, so they're turning to corporate bonds and high-yield bonds. As long as the economic environment remains stable in 2005 and 2006, there will be more money coming in.
Where do you expect default rates to go?
We're currently in a friendly credit environment. Companies that have their share of challenges have been able to come to market. There has been an overwhelming demand for syndicated loans... and a lot of capital looking for yield even after the Fed has tightened four times. I've seen a European insurance company, that I won't name, that never owned bonds before and I asked "why now?" It's because they need spread product. As for default rates, it's a natural part of the cycle. I expect default rates to bottom sometime now or the next quarter and remain low for quite some time. I expect them to remain around 2.5%, below average for 2005-2006.
Don't lose sight of the fact that this is a friendly credit environment. With the combination of a decent economy and a shortage of yield, this can last a while. We have $8 billion in high yield and I've been doing this for many years and there have always been defaults. But in $8 billion of high-yield bonds, I have zero defaults! This is not going away anytime soon. A global recovery is going on; we've already weeded out the weakest credits.
What about the recent surge of triple-C issuance?
The issuance of triple-Cs will be 2006's problems. They haven't come back to hurt us yet, but could be problematic in 2006. But today's triple-Cs are not the same as 1993's triple-C's. Moody's [Investors Service] just downgraded Iron Mountain and I've never seen anything as stupid as that. The company has high margins and number one market share; if anything it should have been upgraded, not downgraded. The rating agencies are being much more conservative. Triple-Cs have much better EBITDA and leverage coverage than previous years. The rating agencies overrated companies in 1999-2001: Enron and WorldCom were rated single-A and then defaulted. They did a bad job in that credit cycle and are overcompensating now.