High Yield Market Overview
The high yield market, as measured by the Credit Suisse High Yield Index, finished the year with a slight uptick, returning 0.57% for the fourth quarter. This brings the full year 2005 return to 2.26%. While the magnitude of these returns is not overwhelming, it is consistent with the relatively low returns across fixed income securities in 2005.
Credit spreads, which measure the yield differential between high quality fixed income and lower quality fixed income securities, impacted performance in both the fourth quarter and full year 2005. Typically, if credit spreads widen (yield difference between quality increases), higher quality investment grade issues may benefit relative to below investment grade issues. Conversely, if credit spreads tighten, high yield bond holders will typically benefit. Over the course of the fourth quarter, as well as full year 2005, credit spreads widened a bit, indicating investors preference for higher quality or lower risk bonds, hurting high yield returns relative to higher quality. The chart below shows the historical credit spreads between the Merrill Lynch High Yield Master Index and the 10 Year Treasury.
The spread difference between the ML High Yield Master Index and the 10 Year Treasury stood at 3.22% at the beginning of 2005, and ended the year at 4.02%. This widening put some pressure on total returns within the high yield universe.
New issuance in 2005 for the high yield market was down versus 2004 levels. However, new issuance was well diversified by industry, and average issue size was in line with the previous year. Overall credit quality of issues coming to market remained low in 2005, with approximately 44% of the new issues coming to market rated B- or below vs. the historical average of 33% (Source: Merrill Lynch).
Default rates remained low in the high yield market in 2005. Through November, the default rate for domestic high yield issues was under 2% (Source: JP Morgan), which compares favorably versus the long-term average default rate of 4.2% for the domestic high yield market. Defaults in 2005 were concentrated within the Transportation (examples: Delphi and Collins & Aikman) and Aerospace (examples: Delta Air Lines, Northwest Airlines) industries. Over half of the full year's total defaults occurred within these two industries.
Within the high yield universe, we believe that convertible issues are currently offering attractive valuations. High yielding convertible issues have experienced selling pressure throughout 2005, as hedge funds employing convertible arbitrage sold into the high yield convertible market. Convertible arbitrage is a popular hedge fund strategy that has a history of delivering consistent returns with low risk. In the recent market environment (marked by low interest rates and low volatility), the returns that convertible arbitrage hedge funds produced have disappointed investors. This disappointment has led to redemptions, which in turn has led to the hedge fund community selling convertible securities. This selling pressure has depressed prices in the convertible bond market, and created some of the best valuations we have seen since 1987. The chart below illustrates this valuation gap. As you can see, valuations have declined within the convertible market over the past 18 months. Historically, we have seen the convertible market trade between a 1.5% discount to a 2.5% premium to our fair value estimate. As of year end, according to our valuation tools, the convertible market is 2.75% undervalued. This selling pressure and decline in valuations has limited the returns in the convertible market this year. A similar phenomenon happened in 1994, as the Federal Reserve was aggressively raising rates, convertible valuations declined. The valuation collapse that occurred in 1994 was relatively short lived and convertibles returned to more normal valuations.
While there is still some hedge fund selling in the convertible market, it is not as intense as it was towards the beginning of the year. We have seen valuations improve somewhat over the past several months, however, valuations still remain attractive.
Current Portfolio Positioning/Outlook
Overall, we believe that the high yield market is fairly valued. Credit spreads remain historically tight, but reflect positive elements in the below-investment grade universe. Currently, the high yield market is benefiting from relatively strong corporate balance sheets, low default rates, and continued strength in the economy. While the high yield market in aggregate looks fairly valued, we are still finding attractive investment opportunities in individual issues through our intensive bottom up analysis. We are focusing on issuers that will benefit from the current economic expansion. We are also favoring issues that may benefit from M&A activity or equity issuance that that may improve the overall credit quality of the issuing company. Given the low quality of new issuance this year, we remained very selective regarding investing in the new issue market—focusing on names with good ROIC (return on invested capital) ratios, sustainable growth, and credit upgrade potential.
As mentioned earlier, high yield convertible issues are currently offering attractive valuations. As a result, the investment team has increased the number of high yield convertible bond issues within the strategy throughout 2005. We continue to favor convertible high yield bond issues in the current environment, as we believe they may offer better risk/reward characteristics than straight corporate high yield issues.