Looming Corporate Defaults Suggest S&P May Retest Lows in 2010 7 comments
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"Hope is a good thing, maybe the best of things, and no good thing ever dies." (The Shawshank Redemption)
If I could sum up the past 4-5 months of market activity into one word, that word would undoubtedly be...HOPE.
There are only a few emotions that are powerful enough to blind someone from reality. Hope is one of the most powerful.
Don't get me wrong, hope is a good thing, but hope is not a strategy...especially not an investment strategy...
Rally of Hope
Even though the macro fundamental data has shown little improvement, the hope of an economic recovery has been strong enough to propel markets higher across the board.
Hopeful of a credit market recovery, yield-hungry investors have now driven corporate bond prices up over 50% from the recent lows.
The S&P 500 is also up about the same amount since hitting a low of 666.79 on March 6, 2009. However, the rally may be running into resistance.
Risk and Reward
The rally in corporate bonds has cut yields in half (see graph below from Altman's recent High Yield Bond Report).
The willingness to accept "junk" bond risk for half the return is somewhat surprising given that default rates are still rising significantly [July 30: High Yield ETFs: Keep this "Junk" Out of Your Portfolio].
In addition, the weighted average recovery rate on defaulting issues so far in 2009 is very low by historical standards. The recovery rate was 22.7% for the first half of 2009. Note that the mean recovery rate from 1978-2008 was 45.07%.
According to Altman's estimates, the U.S. and Canadian dollar-denominated default rate for the last 12 months ended June 2009 rose to 11.08% from 8.01% at the end of the first quarter (see graph below).
As you can see from the graph above, the current default rate (~11.0%) is still below the peaks of the past two recessions (13-15%). And taking into account the reckless lending standards of 2006 and 2007, I think default rates could peak out around 20% this time around...which means we are still only in the 4th or 5th inning of this game...
Default Rates and Equity Prices
Since debt is above the equity in the capital structure, rising default rates tend to put downward pressure on equity prices. If bonds prices are falling, the value of the equity should also fall (and vice versa). This is why equity prices usually bottom out right around the same time that corporate default rates peak.
Let's look at the past two recessions:
- Early 1990s - Default rates peaked in Q4 1990 / S&P bottomed in October 1990.
- Early 2000s - Default rates peaked in Q3 2002 / S&P bottomed in October 2002.
If corporate default rates really do peak around 20% this time around, it probably won't happen until Q1 or Q2 of 2010...and there's a good chance the S&P may be making new lows around that same time...
I hope that I am wrong...
Disclosure: No positions
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I am long commodities (primarily gold and natural gas). However, with regard to equities and bonds, I am primarily looking for setups on the short side right now...
On Aug 05 08:14 AM Mistrofan wrote:
> Very interesting analysis. Thank you. While I agree with equities
> retesting the bottom in 2010, allow me to have a different opinion
> in regards the HYB: the investors will be hard pressed to find any
> refuge to go out of stocks during the next 12 months. T-Bills and
> T-Bonds? No way - at this low interest rate levels. Commodities?
> Maybe - but then you bet on a reflation play which I do not think
> will happend ' till mid '10. What is left? Corporate bonds and TIPS.
> Safer LONG bets for the next 12 months I do not know. Between Corporate
> bonds BAA has a yield of 6.80% already too low. Then investors are
> effectively pushed into HYB. Opinions?
it seems that we agree in a lot of areas: I am already in Natural Gas and hunting for the Gold and Silver. Gold and Silver still a bit to high for my taste. No other commodities - yet.
In regards the bonds:
- AAA Corporate Bonds have yield of 5.29% right now: somewhere in the middle of the range where I like them: 4.89%-6.55%
- BAA Corporate Bonds have a yield of 6.70% right now - the same: in the middle of the range where I like them: 6.55%-7.79%
- Now the High Yield Bonds have a yield of 10.91% by comparison with the range where I like them: 7.79%-9.15%.
- Equities: John Hussman has this Monday a prediction for equities returning a 7% over the next 5 years. Myself I have a calculated return of equities of 7.90% over the same period.
What that means:
1. It means that High Yield Bonds are more attractive then Equities. (At the current prices and for the time being)
2. Because of a compression of AAA and BAA spreads to 10-years T-Bonds, also it means that High Yoeld Bonds are providing a much safer bet then other asset classes.
3. Even if I discount the current 10.91% yield of High Yield Bonds with the current default rate of 11% still I am left with a 9.71% Net yield - which still is over the MAX of normal range - 9.15%.
Summarizing: in my humble opinion, High Yield Bonds offer at the current prices the best risk/reward alternative, my estimated return over the next 3-4 years being 13.92%. A return which will be hard to achieve assumnig less risk than equities & commodities.
On Aug 05 11:06 AM Relative Leverage wrote:
> Mistrofan - I agree with you, it's tough to find good reward-to-risk
> trades right now. Personally, I would rather take the paltry yield
> from investment grade corporate bonds right now than take the risk
> in the high-yield space.
>
> I am long commodities (primarily gold and natural gas). However,
> with regard to equities and bonds, I am primarily looking for setups
> on the short side right now...
"Denial" and/or "disbelief" might be even better.
Far too many seem to think this is just a run of the mill recession.
I dunno, but perhaps, for an "average" conservative investor, holding a chunk of T-bills/bonds, as well as AAA/AA corp. debt isn't the worst thing, if one thinks the market is setting up for a sharp pullback, regardless of the reason(s) for it.
After all, its not like the investor is "married, till death do you part" to the position; its just a means of preserving capital until better times come. For myself, I'm a tad more "opportunistic", so have some gold, and other commodities (oil, primarily), global sovereign debt, etc., but if I was advising a senior citizen, or someone close to retirement, and they weren't comfortable with my choices, that's what I'd probably suggest.