High Yield Securities Need to Refresh

by: Avi Morris

The stock market has had one of its biggest rallies in history. In three months, Dow rose 2200 points (from a depressed level) by one third. Not bad, but it has been stalling in the last few weeks.

The high yield sector in particular appears to be getting over extended. MLPs, REITs and junk bond funds have had stronger recoveries from their lows. The Alerian MLP Index story is repeated in the other sectors. The premium of the yield on MLPs over the 10 year Treasury bond yield narrowed from over 1200 basis points at the lows last year to only 500 points.

By way of comparison, the traditional premium was considered to be 200. The statistics for REITs and junk bond funds are not as good, but the story is similar. Rising stock prices have dramatically reduced their yields while Treasury bond yields have been rising, reducing the yield spread.

The economy seems to have bottomed and is looking for ways to recover. But the rebound may be slow. Housing remains in the dumps and its depressed state may drag on with rising mortgage rates. The auto industry will have to adjust to significant downsizing. Retail sales are sluggish at best. Unemployment shot up to 9.4% and will probably go significantly higher before declining at a slow rate.

Adding to economic worries is the recent rise in the 10 year Treasury bond yield. Early this year it had fallen to record levels approaching 2%, providing a major help to the economy. Government borrowing costs were reduced, of significant value when the Treasury has to borrow trillions to finance huge deficits. In addition many mortgages are tied to the Treasury yield, allowing mortgages rates to fall to record lows. Not any more.

It is important to remember that the high yield sector has not yet gone through its difficult period. Junk bond defaults will increase. The first wave is hitting now after the bankruptcy of General Motors (GMGMQ.PK) and Chrysler. REITs will see higher vacancy rates, estimated to go into double digits.

The rise in MLP index is probably better justified as the industry has had only a few reduce distributions. Most have not had trouble securing additional financing for capital investments or extending debt maturities. But factors driving earnings, and, more importantly, distributable cash flow, are less clear. A sluggish economy may hurt them more than can presently be anticipated.

At this stage of recovery in the markets, a pause to retrench is needed to let investors better assess how the economic recovery will proceed and the impact of the increased government debt load. MLPs, REITs and junk bond funds continue to offer significant yield spreads to cover added risk associated with these investments. But the recent narrowing of spreads looks like it got ahead of itself.