In early August, I wrote: "It still feels like to me that high yield credit just hasn't felt near the pain of equities on the aggregate or on a single name basis." I can confidently say that that pain is now being felt in the high yield market.
"I don't know what's going to happen in Europe but there is one thing I am certain about - eventually, someone is going to take a big loss. As investors, the most important thing we can do is to make sure that we aren't the parties taking that loss."
"We are getting to where it is not easy anymore. We talked about 6 months ago - it was so easy to avoid this junky credit. I remember in March and April, we were talking high yield bonds and CMBX was the most overvalued in history and it was easy to avoid. Now, it has dropped so much, the way we look at it at Doubleline, from a valuation perspective, junk bonds are actually cheap now...Now is the tough part, because the valuation is there, but the technicals and the momentum are terrible. And because of that, it is too early to buy. It is now very difficult because the valuation side of it is supportive of the market.But I think that this thing is going to get a little bit cheaper, particularly as we move forward and we rethinking the earning and default situation, which won't be an imminent turnaround, but when you think about late 2012 or 2013, you are going to be facing higher default rates. And its just not that likely that you are going to get a sustained rally in credit, when defaults are about to move to the upside. It's too early to buy, but the valuation is okay. It's a lot trickier now."
"On the one hand, high-yield bonds and loans look cheap on a relative value basis, effectively already pricing in a high chance of a recession—current high yield bond spreads estimate a 60% chance of recession versus our economists placing the odds at 40%—while implied default rates for bonds and loans based on today’s spread levels are 8.5% and 16.7%, respectively, versus our belief that default rates, in the event of a recession, would only rise to 5-6%. On the other hand, regardless of any perceived value, both markets remain vulnerable to further selling pressure in the near-term while broader market volatility and uncertainty remain extremely high."
If we extend our focus to longer holding periods of one to five years, high yield if purchased from a spread base of 800bp has historically performed quite well. For example, high-yield bonds have provided average annualized returns on a one, two, three, four, and five-year basis of 10%, 14%, 14%, 13%, and 12%, respectively. During the 1-year horizon returns were positive in all 6 examples, albeit with nearly flat returns in the 12-months following the October 2000 and June 2001 examples, a result of a market enduring fits and starts amidst the 9/11 terrorist attacks and corporate fraud situations in 2000 and 2001. Notably, if you had invested in high yield bonds in September 2008 as spreads were first crossing 800bp, you would have endured spreads widening to a record high 1900bp during the next 12 months and still managed to record a +5.7% return."