High Potential from High Yields

02/04/2009 1:00 pm EST

Focus: ETFS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of Vardy’s Global Bull Market Alert, says there’s too much fear about corporate defaults, and he thinks high yields are deeply oversold.

iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) is a bet that the extreme risk aversion of investors toward corporate borrowers—specifically as reflected in the spreads between high yield debt and US Treasurys—will abate over the coming months.

Corporate bonds were sold off with abandon when fear gripped global financial markets in October. But as with the sell-off in global stock markets, this was overdone. Even if the global economy will face enormous challenges in the coming year, corporate balance sheets remain healthier than the current spreads on corporate debt would indicate.

Yes, high yield-default rates, which ran at just 3.4% in the past 12 months, are certain to spike in 2009. Moody's Investors Service expects the US high yield-default rate to top 10% in the next year. Barclays Capital is predicting a rate of 14.3% by the second half of 2009.

But at the worst of the Great Depression—a 30% drop in GDP with 25% unemployment—only about 15% of issuers defaulted. And with a 20% average yield (compared with 9% at the start of 2008), even these extremely bearish scenarios are more than reflected in the price of corporate debt.

According to Barron's, the average high yield issue trades for less than 60 cents on the dollar. That means that defaults might have to run at a cumulative 50% rate in the next five years and recovery rates average just 30 cents on the dollar—versus a historical average of about 40 cents—for investors to get subpar returns.

Investors are slowly catching on. High yield bond spreads—the spread between high-yield debt and “risk free” US Treasurys—are already narrowing. Merrill Lynch's high-yield bond index gained more than 6% in December, the strongest monthly increase since 1991. Today, high yields are down to about 18% from 22.5% a month ago, and back to levels we saw before the US presidential election and the run on Citibank. Yet even after the recent rally, the spread between corporate bonds and Treasurys still is off the charts relative to their historical averages.

Finally, the high yield market declined about 27% in 2008—its worst showing in the past 20 years. If history is any guide, 2009 should be better. Down years like 1990 often have been followed by big gains. Given the complex relationship between price and yield, it wouldn't take much for high yield debt to return 20% in 2009.
 
So, buy the iShares iBoxx $ High Yield Corporate Bond (HYG) at market today and place your initial stop at $62.90. (It closed Tuesday at around $73—Editor.) If you want to play the options, I recommend the June $77 call options (HYGFY.X). Be careful, though. The liquidity in these options is very limited.

Subscribe to Vardy’s Global Bull Market Alert here…

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