INSIGHTS

On October 07, 2011

Euro Crisis Presents Buying Opportunity in U.S. Corporate Bonds

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We feel as though the markets are trading as if the long-feared double-dip recession is becoming a real possibility. While we expect that Europe will be unable to avoid a recession, we don't expect one in the United States. We're still 60/40 against it and if it comes, we don't believe that it will be anywhere near as severe as the '08/'09 recession. We see Asia possibly slowing materially, as Europe is their biggest market, but don't see a recession there. Overall we see global markets slowing – but feel the only true recession that's most likely is in Europe.

If there is another U.S. recession, we don’t believe there will be a bailout of the auto industry, or another Lehman or AIG. Fanny & Freddie are already under more or less conservatorship. A lot of people have already run through their unemployment insurance and hiring has yet to take off so we don’t think we’ll see much of a new wave of newly unemployed. Housing is a mess, but most of the damage is already done, in our opinion, as we feel markets are more transparent and investors are more cautious now.

If you look at what the corporate bond market did during the last downturn, there was about a year when spreads blew out, far wider than in a very long time, and recovered; Sep '08 – Sep '09. The reason for the extreme blowout was fear that the market would not be willing to refinance maturities – given where secondary bonds were trading. If that happens, default rates would potentially soar. But step by step, starting with the best credits first, the market did step up. Defaults did not spike and we had two years in a row of record new issues. A year later, spreads were back to '07 levels. We don’t see the same level of panic – even if we repeated the severity of the last recession given the resiliency demonstrated so recently. Additionally, we don't expect that if there were a new recession it would be as severe as the last one. We also don't believe the downside would be anywhere near as great.

Furthermore, corporate balance sheets are much stronger – both in their cash positions and their debt maturity schedules – than they were going into the last recession. So far, there have not been very many meaningful downward revisions of earnings estimates. For these reasons, we don't anticipate a material rise in defaults in the near term other than CCC's – which have a track record of seeing their default rate pick up whenever the economy drops below a 1.5% growth rate. We see very little increase in default potential in the BBB-rated category and expect that BB-rated issuers, in general, will have little difficulty accessing capital as well.

Right now, we're getting paid spreads that are at the same level as mid-'09, when the 5-year U.S. Treasury was at 2.5%, not the 88-basis points it is today. The S&P 500 was 180 points lower than it is today. So the bonds are cheaper today versus the last time they paid so much, in view of the lower interest rate environment and higher equity prices. On top of that, add that we also have the Bernanke pledge to hold cash rates at near zero for the next two years, greatly limiting duration risk on shorter-term products, which have the potential to make their risk/return profile even better. In the short term, if Greece debt can be solved without a default, we expect the market to stage a strong rally and credit spreads to narrow noticeably resulting in a nice gain for current buyers.

In conclusion, we're not saying that things couldn't continue to trade lower if the United States goes into another recession. We're saying that right now the bonds are noticeably less risky than the last time they yielded this much. Bonds bought then have had great returns and are now so short in maturity that they have little duration risk today. We believe that buying today will repeat that experience in the next two years. Even if we slip badly and go through another tough recession – which we don't anticipate – we expect that default rates will be surprising low outside of CCC credits and that the market will not fall nearly as far as it did last time. However far it falls, if the recession comes we expect that it will spring back in a time frame similar or shorter to last time and that in a relatively short period bonds bought today could be trading at spreads at or inside today's levels. If that is the case, investors will have reaped the attractive current yield in a record-low interest rate environment and still be looking at a mark to market gain. There also exists a near-term opportunity should the Greece situation get solved in a way that seems to eliminate the possibility of a default of any European Union (EU) country in the next couple of years, wherein we would expect a strong market rally. If that happens, and we avoid a recession, we should not expect to see today's high spreads again for quite some time.

This report was produced by Navellier & Associates and is for informational purposes only. Advisors Asset Management, Inc. (AAM) has not independently verified this information and makes no recommendation regarding its accuracy. This report should not be considered an offer to purchase or sell securities and AAM may make a market in or have financial interests in any given security discussed. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com. 

 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.