High Yield Strategy: Expectations for 2011

As most of you know, I spend a large portion of my time investing in the high yield asset class. This has been a fruitful effort this year with high yield return about 13% this year. A lot of this performance was due to the tightening of the treasury curve (10 year treasuries returned about 10% this year). High yield spreads are at 600bps now, starting the year 650bps. All returns are not made equal and our call on investing in the cross over space has outperformed on a total return basis.

With that said, I always like to look at what strategists are saying for next year. This year the returns expectations are in a fairly tight range with a few outliers. For example, Banc of America is forecasting total returns of 10.3% for 2011. JP Morgan is forecasting an 8% return. And Barclays is projecting a 5-6% return.

While I am not a top down kind of guy, it is important to remember some of the factors that will contribute and detract from total returns next year:
  • Assumptions of default rates
  • Treasury curve
  • Prices and call prices
  • Relative value
  • X Factors
Let's take a look at these in turn.

Assumption of Default Rates

High yield and leverage loan strategist use the forward looking default rate and recovery rate assumptions to make total return forecasts of the respective asset classes for next year. This year bonds and loans defaulted at a rate of about 2% and 3% respectively by count (versus by par amount which is lower for both high yield and leveraged loans). The consensus for next year among the various strategist is 1-3% for both asset classes - with most experts forecasting bonds to have a lower default rate versus loans.

As most people in the credit markets are aware, the 2011 maturity schedule is scant. In 2011, approximately ~$50B of high yield bonds mature as well as ~$20B of leveraged loans. To give you a sense of that relative size, there has been over $280B of new issue activity this year (all time record). Even in the doldrums of 2002 and 2008, high yield did over $50B in supply.

While there is always a chance that liquidity dries up dramatically because of some exogenous event (terrorism, massive fraud, etc - see X Factor section), I too believe default rates will be low next year. I also believe that recovery rates will be lower than expected on the gut feel that if a stressed issuer has not refi'd into the ridiculous supply we've seen this year, the business must be horrible to begin with.

Treasury Curve

As can be seen from returns this year across fixed income products, the treasury curve is one of the most important variable to look at when calculating forward looking returns. I may have missed one or two strategies in my research of the bulge brackets, but consensus across Wall Street is for an increase in treasury rates across the curve. And this is important because as coupons for high yield have decreased and maturities have extended, duration has increased. We are looking at some of the lowest coupons across the rating spectrum as well as the steepest credit curves I can remember - the curve definitely matters more today than in most previous cycles.

The chance of a Fed increase is quite small throughout the year. Using FFIP on Bloomberg, one can see that for the November 2011 Fed meeting, there is a 26% chance of an increase to 50bps, a 7% chance of an increase to 75bps, a 45% chance of no change, and a 21% chance of a decrease to 0.

With that said, if market participants start to see inflation expectations begin to pick up in CPI, PPI, etc the treasury curve will rise. If you look at what makes up CPI you can get a good sense that numbers will start to tick higher. Let's go through them:
  • Food ~ 15% of basket. Food deflation is the talk of the town among grocers though expectations are for normalization next year. Let's call it flat.
  • Housing ~ 42% of basket with OER being a large portion of that with the balance going to utilities. Listen to most of the apartment REITs and they will tell you they have regained pricing power in all but the worst areas. Utilities definitely going higher. Housing costs going up.
  • Apparel ~ 4%. Look at cotton. Definitely going higher after 10 years of apparel deflation.
  • Transportation ~ 17%. Made up of vehicles and fuel. Vehicle prices probably going higher. Fuel more than likely going higher.
  • Medical Care ~ 7%. Don't even need to explain - going higher.
  • Recreation ~ 6%. This is a catch all for many categories. I'll call it flat.
  • Education ~ 6%. Definitely higher.
  • Other goods (tobacco + personal care) ~ 3%. Tobacco higher, personal care flat.
Just looking at that list you can see CPI will be higher. And I have a sneaking suspicion that even in spite of very high unemployment rates, you will see wages go higher. And let's not forget the ballooning of the Fed balance sheet or that M2 which was growing at 1% per year in March of 2010 is now growing at over 3%.

So I agree with the strategies - in my opinion in spite of the Fed holding tight, treasury rates will increase across the curve.

Prices and Call prices

About 9 out of every 10 bonds issued in the high yield market have call protection schedules. And according to a recent Banc of America piece that average price at which high yield bonds are callable today is 104. Currently, the average high yield bond is trading slightly less than par (it had gotten to as high as 102) so this call schedule theoretically should act as a speed bump for returns.

The current yield in the high yield market is about 7.8%. With that said, I think it is a stretch to think that the entire high yield market will trade to 104 without another leg down in the treasury curve which as mentioned above, we do not believe will happen.

Higher dollar prices also imply higher losses in defaults. As the market starts to look out to 2013 and 2014 where maturities are a serious issue it is my opinion that prices will begin to decline. But that is more of a early 2012 factor.

Relative Value

One reason I can get bullish on high yield is the fact that it's one of the best yielding asset classes in a sea of incredibly tight rates. Investment grade is getting ridiculous, municipals, in spite of recent weakness, are still tight (and have serious fundamental factors against it), EM debt is at an all tight low, bank debt is marginally attractive if not for the nearly free call option on rates, ABS (outside of CLO paper) is too tight, RMBS and CMBS are very attractive in some instances, but still on the whole, not terrible enticing.

With that said, on a daily basis I wear two hats: total return and spread products. Some of the money I help manage has to be invested (think insurance and pension money). In these accounts, I think select, high quality high yield with some positive tail events (make whole premiums, early take outs, no LBO risk) are the place to play. On a total return basis, not so much.

X Factors

Things like European sovereign woes, more failure of Congress to get their issues in order (How can I be writing this in the December and still not know what my tax rate will be next year), municipal budgets, terrorism risk, mortgage put backs, China currency and interest rate policy, etc. Hard to handicap some if not all of these. Seth Klarman has always talked about "disaster insurance." That is definitely the best way to play these. Yes you lose a small bit of performance if nothing happens, but if things get really bad, your 2011 returns will outperform.

Another thing I'll lop into X Factor are the animal spirits that have pervaded high yield and credit products in general in 2010. All time high in new issuance. This causes me to be very cautious putting money to work - call me contrarian if you must.

All in All

Low default rates combined with higher rates and probably flat spreads gets me to a 6-8% return for high yield in 2011. If I had to pick a number I feel like closer to 6% because inevitably one of those X Factors will show up (let's hope its not my tax rate going up). Here's to hoping.


Anonymous,  12/07/2010  

Food PXs in EM have been skyrocketing recently. Don't think you're going to get flat food PXs in developed markets with the kind of increases you're seeing in the grains complex commodities.

Anonymous,  12/07/2010  

How does a continued high level of unemployment leading to potential deflation fit into this discussion?


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.