A bank defers any potential defaults into the future by rolling over its loans rather than forcing them to be repaid. For the corporate sector, the excess financial market liquidity resulting from central bank money printing leads to ample access to debt refinancing. As such, we expect continued support for low default risk in high yield keeping this sector a core position for income, though modestly rising rates should limit price appreciation.
The financial crisis response to both the US credit crisis of 2008 and the rolling European sovereign crises since then have been to flood the world with liquidity. Simply put, the world's central banks fight financial market risk through printing money (Figure 10). The target source of risk for each crisis may be different — housing for the US, sovereign risk for Europe — but the unintended beneficiary remains the same: the corporate sector. Default risk is first and foremost liquidity risk, as loss of access to financing markets plunges a company straight into default on the maturity of its debt.
However, "a rolling loan gathers no loss," meaning that a bank defers any potential defaults into the future by rolling over its loans rather than forcing them to be repaid. For the corporate sector, the excess financial market liquidity resulting from central bank money printing leads to ample access to debt refinancing. Since 2009, refinancing activity accounts for over half of all corporate issuance activity in the below investment grade corporate bond markets — the source of most corporate default risk. We expect much of the same for 2012: continued support for low default risk in high yield from ample financial market liquidity.
Such high levels of liquidity should again keep default rates low in 2012. Spreads in high yield measuring the degree of risk compensation over Treasury yields remain historically wide to the low level of default risk we expect in 2012 (Figure 11). While rising interest rates may pose some challenge to the price performance of the sector, these wide spreads provide an attractive cushion to the potential for increasing rates. Narrowing spreads in an environment of rising interest rates should keep prices stable and returns from the sector likely concentrate around current yields making the sector attractive from an income point of view, though total returns likely remain far below those posted in the immediate aftermath of the 2008 crisis.
Figure 10: Global Central Banks Run the Printing Presses Overtime
Figure 11: High Yield Spreads Attractive Relative to Forecasted Defaults
Source: BofA Merrill Lynch, Moody's
Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities ("high yield" or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.
Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
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