O Why High Yield Corporate Bonds Will Remain Attractive in 2012

1.1 WHITE PAPER
Why High Yield Corporate Bonds Will Remain
Attractive in 2012
TREVOR WILLIAMS
Chief Economist
Lloyds Banking Group
O
ver the period since the financial crisis started in 2007,
the high yield corporate bond market has had a roller
coaster ride. First of all, it was badly hit by the flight to ‘safety’
that ensued after the failure of Merrill Lynch and then Lehman
Brothers. Now, though, yields have fallen dramatically, to
below where they were before the credit crisis in 2007. This
is despite a deep recession and continuing economic and
financial market turmoil in the advanced economies. One of
the main reasons for this is that prospects for household and
government debt look so gloomy.
FINANCIAL MARKETS ARE SCEPTICAL ABOUT GLOBAL
GROWTH
Very low interest rates for the foreseeable future imply that
financial market interest rates have a very sceptical view of
global economies prospects for the next two to three years.
Whilst these expectations are not as negative as they were in
the immediate aftermath of the financial crisis, they remain
poor. Global government bond markets (outside of countries
where debt default risks are seen as exceptionally high) reflect
a very negative outlook, with bond yields at generally low
levels as short term interest rates are expected to remain at
record lows.
Chart 1: US corporate bond yields have fallen sharply
11
Yield, %
THE MOST SIGNIFICANT RISK IS FROM THE
EUROPEAN SOVEREIGN DEBT CRISIS
10
US BAA corporate bond
9
8
7
6
5
US AAA corporate bond
4
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
Weaker global growth prospects have resulted in a cut to
consensus forecasts of world output growth forecasts for both
this year and next, to 4% in each year. Meanwhile, international
developments and negative news coming out of the euro
area have served to chill and exacerbate weakening business
sentiment almost everywhere.
07
The world economy would be impacted
significantly by a disorderly Eurozone default,
where it breaks up and there are contagion
effects. Uncertainty over the US debt ceiling
and credit rating has added more volatility
to world financial markets. Meanwhile, high
inflation remains a key risk in countries like
Brazil, China and India and, though off their
peaks, commodity prices remain stubbornly
high.
Global imbalances remain an issue with big
current account surpluses in some parts of the
world and big deficits in others. The limits of
fiscal and monetary policy options have been
exhausted in developed economies. And
finally China could slow sharply, presenting
08 09 10 11
major risks as it is such a big player in terms of
global growth trends.
Regarding the Eurozone, it is now accepted that a Greek default
is unavoidable. The big challenge for Europe’s politicians is
to make decisions that minimise the risk of Greece’s default
occurring in other countries – so-called contagion. The latter
would emanate from bond holder losses, including bank
losses, insurance companies and pension funds, which would
feed through to lack of confidence in financial markets.
Why High Yield Corporate Bonds Will Remain Attractive in 2012
As a result, money markets would be in danger of freezing
up just as they did after the Lehman crisis, credit would be
squeezed with less money for households and companies
would delay spending. Government intervention would likely
be inevitable, despite the risk to their balance sheets.
UK ECONOMY IMPACTED
Even though the UK is not part of the single currency, a euro
break-up would cross the channel to impact its economy.
This would come at time that UK economic growth is looking
particularly poor, just 1% expected in 2011 and a similar pace
for 2012. Any slowdown in Eurozone growth that is more than
expected currently – and the consensus is for roughly 0.5%
growth - would hit the UK hard, perhaps resulting in a brief
recession.
US STILL A SAFE HAVEN?
However, despite all the issues facing the US – high debt
levels, explosion of government debt – the US dollar remains
a safe haven. It remains the international economic currency
with the biggest and most liquid financial markets. There
is no real alternative to the dollar and as such it remains the
global safe haven at times of extreme stress. Some currencies
have appreciated versus the dollar: the Chinese, Brazilian and
Mexican for example. Other strong currencies are associated
with countries that have with either large services exports or
large manufacturing exports, like Taiwan and India.
RISE IN COMPANY PROFITS AND FALL IN DEBT SUPPORT
HIGH YIELD DEBT MARKET
Not surprisingly, therefore, equity markets are pessimistic
and reflect a negative view of world growth prospects. But
the crucial difference between the corporate sector at the
aggregate level and some of the other sectors in the economy
is that firms have cut debt levels more deeply and profits are
rising quite sharply. Of course this is not true for all firms in the
advanced countries but it is true for enough in the economy
at the macro level to resonate. Interestingly, this is the case for
the US, the UK and the Eurozone.
For the US, this translates into one of the best balance sheet
position since the 1950s, see chart 2. It is also the case that
with greater turmoil in other asset classes persisting, high yield
corporate bonds are perhaps seen as offering good returns for
the risk. This is especially the case in an environment where
the yield for the highest rated companies has fallen to below
that of many top rated sovereigns. This has prompted some
to call triple ‘a’ rated companies bonds, the new ‘risk free’ rate.
CHART 2: US COMPANIES’ CASH POSITION BEST SINCE 1950S