1.1 WHITE PAPER Why High Yield Corporate Bonds Will Remain Attractive in 2012 TREVOR WILLIAMS Chief Economist Lloyds Banking Group O ver the period since the financial crisis started in 2007, the high yield corporate bond market has had a roller coaster ride. First of all, it was badly hit by the flight to ‘safety’ that ensued after the failure of Merrill Lynch and then Lehman Brothers. Now, though, yields have fallen dramatically, to below where they were before the credit crisis in 2007. This is despite a deep recession and continuing economic and financial market turmoil in the advanced economies. One of the main reasons for this is that prospects for household and government debt look so gloomy. FINANCIAL MARKETS ARE SCEPTICAL ABOUT GLOBAL GROWTH Very low interest rates for the foreseeable future imply that financial market interest rates have a very sceptical view of global economies prospects for the next two to three years. Whilst these expectations are not as negative as they were in the immediate aftermath of the financial crisis, they remain poor. Global government bond markets (outside of countries where debt default risks are seen as exceptionally high) reflect a very negative outlook, with bond yields at generally low levels as short term interest rates are expected to remain at record lows. Chart 1: US corporate bond yields have fallen sharply 11 Yield, % THE MOST SIGNIFICANT RISK IS FROM THE EUROPEAN SOVEREIGN DEBT CRISIS 10 US BAA corporate bond 9 8 7 6 5 US AAA corporate bond 4 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Weaker global growth prospects have resulted in a cut to consensus forecasts of world output growth forecasts for both this year and next, to 4% in each year. Meanwhile, international developments and negative news coming out of the euro area have served to chill and exacerbate weakening business sentiment almost everywhere. 07 The world economy would be impacted significantly by a disorderly Eurozone default, where it breaks up and there are contagion effects. Uncertainty over the US debt ceiling and credit rating has added more volatility to world financial markets. Meanwhile, high inflation remains a key risk in countries like Brazil, China and India and, though off their peaks, commodity prices remain stubbornly high. Global imbalances remain an issue with big current account surpluses in some parts of the world and big deficits in others. The limits of fiscal and monetary policy options have been exhausted in developed economies. And finally China could slow sharply, presenting 08 09 10 11 major risks as it is such a big player in terms of global growth trends. Regarding the Eurozone, it is now accepted that a Greek default is unavoidable. The big challenge for Europe’s politicians is to make decisions that minimise the risk of Greece’s default occurring in other countries – so-called contagion. The latter would emanate from bond holder losses, including bank losses, insurance companies and pension funds, which would feed through to lack of confidence in financial markets. Why High Yield Corporate Bonds Will Remain Attractive in 2012 As a result, money markets would be in danger of freezing up just as they did after the Lehman crisis, credit would be squeezed with less money for households and companies would delay spending. Government intervention would likely be inevitable, despite the risk to their balance sheets. UK ECONOMY IMPACTED Even though the UK is not part of the single currency, a euro break-up would cross the channel to impact its economy. This would come at time that UK economic growth is looking particularly poor, just 1% expected in 2011 and a similar pace for 2012. Any slowdown in Eurozone growth that is more than expected currently – and the consensus is for roughly 0.5% growth - would hit the UK hard, perhaps resulting in a brief recession. US STILL A SAFE HAVEN? However, despite all the issues facing the US – high debt levels, explosion of government debt – the US dollar remains a safe haven. It remains the international economic currency with the biggest and most liquid financial markets. There is no real alternative to the dollar and as such it remains the global safe haven at times of extreme stress. Some currencies have appreciated versus the dollar: the Chinese, Brazilian and Mexican for example. Other strong currencies are associated with countries that have with either large services exports or large manufacturing exports, like Taiwan and India. RISE IN COMPANY PROFITS AND FALL IN DEBT SUPPORT HIGH YIELD DEBT MARKET Not surprisingly, therefore, equity markets are pessimistic and reflect a negative view of world growth prospects. But the crucial difference between the corporate sector at the aggregate level and some of the other sectors in the economy is that firms have cut debt levels more deeply and profits are rising quite sharply. Of course this is not true for all firms in the advanced countries but it is true for enough in the economy at the macro level to resonate. Interestingly, this is the case for the US, the UK and the Eurozone. For the US, this translates into one of the best balance sheet position since the 1950s, see chart 2. It is also the case that with greater turmoil in other asset classes persisting, high yield corporate bonds are perhaps seen as offering good returns for the risk. This is especially the case in an environment where the yield for the highest rated companies has fallen to below that of many top rated sovereigns. This has prompted some to call triple ‘a’ rated companies bonds, the new ‘risk free’ rate. CHART 2: US COMPANIES’ CASH POSITION BEST SINCE 1950S