Liquidity Keeps High Yields’ Yields High

03/21/2007 12:00 am EST


Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, tells why he thinks the yields on high-yield bonds are unsustainable in the long run and why this is not the time to buy these bonds.

One of the surprising events of the last year has been the refusal of high-yield bonds (those rated BB, B and CCC) to begin defaulting or to start declining in price. Yield spreads are now below historical default levels, giving rise to criticisms that the market is not being rational.

High yield debt is benefiting from the high liquidity currently present in all of the debt markets. Such liquidity is allowing junk-rated issuers to restructure their debt maturities to head off possible default situations. This in turn instills a general sense of confidence in the market.

Adding to the yield decline and narrowing spreads is the fact that there are fewer alternatives available today that still pay 7% to 9% yields. This is important to portfolio managers, who are paid for performance.

Although average yield spreads may no longer cover average default risk, most managers with any self-respect consider themselves well above average. Hence, they don’t expect to have anywhere near the 3% to 5% average default loss that an economic downturn might produce. They’ll continue to buy high yield in order to keep pace with their peers.

What they ignore is that when the default wave comes, the one- or two-year default rate shoots up to 15% or 20%, not the average 5%. Bottom line, this is not the time to buy a high yield bond fund.

What is overlooked in the declining spreads for high yield debt is that this spread is not only supposed to compensate for default risk, but also for high yield’s higher illiquidity when the economy contracts. Most of the holders of such debt are a relatively small group of large institutions who in a junk market correction, find everyone is on the sell side of the market.

The world liquidity glut has removed any liquidity risk considerations from current pricing. Yields on preferreds continue to run 100 basis points and more ahead of those for comparable bonds. This has nothing to do with comparable risk but everything to do with liquidity.

Those of you who have money in equities as well as fixed income should be planning on a further allocation into equities as soon as this latest “correction” has run its course (no advice from me as to just when that will be.) Chances are that once the stocks have recovered and you decide to reallocate back into income securities, they’ll still be pretty much where they were when you stepped out of them temporarily. It is this ability to make such re-allocations that makes a portfolio balanced between fixed income and equities so much better for the long run.

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