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Compass Financial - Market Update Oct 27, 2008
Compass Financial - Market Update Oct 27, 2008
Compass Financial - Market Update Oct 27, 2008
Market Update
Adam Norman
Research Analyst, Fixed Income Strategy, LPL Financial
October 24, 2008
8.0% 800 closed Monday October 20, at 1554 bps, well above its record high, set
6.0% 600 in October 2002. High yield bonds have priced in deteriorating economic
4.0% 400 conditions and a rapid increase in default rates well in advance of actual data.
2.0% 200 The following chart shows quarterly data, going back to 1982 and therefore
0.0% 0 excludes the current month. Remarkably, spreads have widened out almost
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500 basis points in the month of October, marking the current environment
Source: Moody’s, Lehman, LPL Financial as the worst high yield market ever.
The trailing 12-month default rate for U.S. speculative grade issuers has
increased steadily since December 2007, when it was just 0.9%, its lowest
level since 1981. Moody’s most recent calculation estimates a default rate of
3.4% as of the end of September, still below its historical average of around
5%. Yet the average price of a high yield bond has declined to 65 cents on
the dollar, only slightly exceeding its record low. Using an average recovery
rate on a defaulted bond of 30 cents on the dollar (which is below the long-
term average of 40 cents on the dollar) and factoring in the more than 18%
yield, implies a default rate of greater than 20%. While we agree that default
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MARKE T UP DAT E
rates will continue to increase, we do not expect them to reach the levels
implied by current pricing. In the last 30 years, the default rate reached
more than 10% just twice, peaking at 13% in June 1990. S&P forecasts
that the default rate will increase to 7.6% over the next 12 months, while
Moody’s forecasts a default rate of 7.9% a year from now. In our opinion,
investors are being more than compensated for the risk that defaults will
increase to their record levels. The average price of a corporate bond
has simply fallen off a cliff over the last month, as evidenced by the
following chart.
2 Lehman Corporate High Yield Average Price High yield bonds have historically demonstrated exceptional performance
following periods of extraordinary yields. Since 1987 (the earliest time for
110
which Lehman data is available), a 14% yield threshold has been breached
105
100 only four times, other than the current period. Each coincided with a
95 financial crisis and includes: October 1987, February 1989, November
90
85 2000 and October 2002. Starting with the following month, the 12-month
80 total returns of the Lehman U.S. High Yield Index were: +17.31%, -5.25%,
75
70
+8.09%, and +33.77%. During the 1989-1990 timeframe, yields were still
65 on the rise, and ultimately peaked at 20.94% in December 1990. Over
60 the following 12 months, the Index returned +46.19%. Picking the peak in
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yields will prove nearly impossible, but when yields eventually decline, the
benefit to the asset class is evident.
Source: Lehman, LPL Financial
Do to significant issuer risk, we do not suggest purchasing individual high
yield bonds. Rather, we recommend an open-end mutual fund, due to the
importance of credit research and diversification.
While we find current valuations on high yield bonds compelling, we
caution that we do not expect yield spreads to compress to the same
degree and speed in which they sold off. Financial conditions will improve
over time, but investors’ risk appetite may remain subdued for several
months. If default and recovery rates ultimately remain at manageable
levels, high yield investors with a long-term time horizon ought to be
handsomely rewarded. Since 1983, the high yield bond market has
posted negative total returns only four times. The year-to-date returns
through October 21, 2008, already exceed the total of those four years
combined. Credit markets tend to move in cycles and we expect spreads
to eventually tighten. Even if spreads fail to revert to their mean, and
stay rooted at current levels, the current coupon income provides an
attractive return.
IMPORTANT DISCLOSURES
Municipal Bonds are subject to availability and change in price. They are also subject to market and interest
rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject
to alternative minimum tax. Federally tax-free but other state and local taxes may apply.
High yield/ junk bonds are not investment grade securities, involve substantial risks, and generally should be
part of the diversified portfolio of sophisticated investors.
Investing in mutual funds involves risk, including possible loss of principal. Investments in specialized industry
sectors have additional risks, which are outlined in the prospectus.
The opinions voiced in this material are for general information only and are not intended to provide specific
advice or recommendations for any individual. To determine which investment(s) may be appropriate for you,
consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of
future results. All indices are unmanaged and cannot be invested into directly.
Investors should consider the investment objectives, risks, charges and expenses of
the investment company carefully before investing. The prospectus contains this and
other information about the investment company. You can obtain a prospectus from
your financial representative. Read carefully before investing.
Principal Risk; An investment in Exchange Traded Funds (ETFs), structured as a mutual fund or unit investment
trust, involves the risk of losing money and should be considered as part of an overall program, not a complete
investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility,
competitive industry pressure, international political and economic developments, possible trading halts, Index
tracking error.
Investing in Mutual Funds involves risk, including possible loss of principal. Investments in specialized industry
sectors have additional risks, which are outlines in the prospectus.
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