Investors brace for more trouble ahead

High-yield spreads have now widened to close to 2002 levels as a result of the turmoil on Wall Street. The Merrill Lynch High Yield Master II index recorded a spread to Treasuries of 987bp last Thursday. The last time spreads approached 1,000bp was in November 2002, when they hit 994bp.

While such levels suggest juicy returns may be possible, investors are instead focusing on the potential for further widening of credit spreads. Hopes early in the week sparked by the US Government’s US$700bn bail-out plan turned to disappointment on Thursday night when the plan stalled, sending financial markets lower on Friday.

But even if the plan is approved, investors say they cannot ignore the problems facing high-yield issuers. “The short-term markets are in disarray; companies are having trouble funding. It’s still quite alarming,” said Wes Sparks, head of US fixed income at Schroder Investment Management. Weak economic data out last week contributed to the negative sentiment.

Now, in such a restrictive lending environment, concern about a rising default rate is growing as more companies trade at distressed levels.

“The distressed ratio is unique in this cycle because of the number of investment-grade issues that are trading at distressed levels,” said Christopher Garman of Garman Research. “The TARP program can help break this vicious cycle that capital markets are currently trapped in, as it will likely free-up some capital flow for high quality issues, but there are a very sizable number of low quality issuers that may not be able to access capital going forward and are looking at a higher probability of default.”

The percentage of distressed issues, defined as those issues trading above 1,000bp, in the Merrill Lynch High Yield Master II index rose to 34.6% at September 18, up from 27.9% at the end of August. According to Garman Research, which publishes Leverage World, its default rate predictor forecasts a 10.09% one-year default rate for September 18, based on that percentage. Comparatively, Moody’s reported a trailing twelve-month US speculative grade default rate forecast for August 2009 of 8.4%. The current US default rate stands at 3.3%, up from 1.4% a year ago.

Default rates may not climb significantly for another six to 18 months, though near-term concerns are weighing heavily on the market. The bail-out, if passed, may create a rally, but questions remain.

“Are investors going to become more risk-averse and use a rally to sell?” asked Sparks. “I think there are a lot of accounts that have cash, so if there are positive enough catalysts you could see some buying. But at the margin the balance is tilted in favour of caution.”