Registered Rep. spoke with Greg Hopper about how the liquidity crisis has affected high-yield issues.
RR: There has been a flight to safety, and the spreads between risky corporate debt and Treasury yields have widened. Do you expect this to continue?
GH: The measure I look at is a few basis points shy of 500 right now. In other words, you are being paid 5 percent above a riskless Treasury rate to take on high-yield corporate risk, on average. While there is much to be concerned about, between sub-prime woes and a weaker U.S. consumer, there is also much to take solace from in today's global economy. And 500 basis points is beginning to overcompensate for the risks.
RR: Is that spread about average?
GH: Over long periods of time, yes. But it's the old “median versus average” problem. High-yield spreads have a tendency to spike to 1,000 basis points or more for short periods of time, but live most of the time in the 250- to 400-bps area, so the median is more like low 400s. And lets not forget, we don't eat spread — we eat total return. So, while spread changes can impact the principal of your high-yield bond or portfolio, there is a reason they call it high yield (rather than junk!). The yield, which today is almost 9 percent, can cover a lot of sins. In fact, at current yields, spreads could spike out to 700 basis points — and treasuries stay flat — over a year's time; you would still break even, since the coupon would roughly cover principal volatility.
RR: Aren't high-yield bond holders higher up the food chain than equity holders?
GH: That's right. If the environment were challenging enough to widen high-yield spreads an additional 200 basis points, matters [would] be far worse in equities, which are subordinate to high-yield bonds. Historically, the worst rolling 12-month total return in high yield, using Merrill Lynch indexes, is -8.36 percent versus -26.59 percent for the S&P 500. The best rolling 12-month period for high yield has been 37.34 percent versus 52.11 percent in equities. So the real wild-west ride is over in the equity park.
RR: How have you sheltered your fund from the recent turmoil?
GH: We take a broad approach, and diversify both geographically and up and down the balance sheet. Even before this summer, we added a significant percentage of senior loans to the portfolio, which should be less volatile. Our positions outside the U.S. have also proven less vulnerable.
