C.M.O. 2.18.2009

Credit Market Overview
February 18 2009

One of the keys to successful investing it is said is to follow the “smart money”. This used to mean (before 2008) do what the professionals do when they do it, not what the individual investors do when they do it.

In this context a story in yesterday’s WSJ seems apropos in that individual investors have been big buyers of high-yield paper and as a result have pushed yields down to around 11% from rates in the high teens seen during the 4th quarter of 2008. Fund researcher EPFR Global says individual investors have purchased more than $4BN of high-yield bond funds since last November.

For all of their lack of sophistication it seems that individual investors are getting the joke as the WSJ also reported that money-fund assets have grown by $450BN since last September and are close to their all time record of $4TN.

Put most of your money in a safe bet and take a flyer on a small portion that if it works out will boost the performance of your whole portfolio by some incremental amount. A strategy like that would have worked wonders last year and to the extent we’re not out of the woods yet it can’t be said it’s the worst strategy for 2009. Maybe some of these people should be running hedge funds.

Now before the rest of us start feeling like we missed something there is a “fly in the ointment” and that is that high yield bonds pay high rates of interest because they have high rates of default. No risk, no reward and vice versa.

The economic situation at the moment seems to be raising the risk of defaults as Circuit City (11/10/2008); Nortel (1/14/2009); Tribune (12/8/2008); Pilgrim’s Pride (12/1/2008); Smurfit Stone (1/26/2009); LyondellBasell (1/6/2009); Spectrum Brands (2/3/2009) and VeraSun Energy (10/31/2008) have all filed for Chapter 11 bankruptcy since 4Q08.

To further the point the three main credit rating agencies expect default rates to hit levels last seen in 1933 according to Moody’s Investor Service’s 87 year’s worth of default data. According to the WSJ, as of 2/6/2009 U.S. companies have defaulted on $43.1BN of high yield and bank debt, which the article goes on to say, is higher than 2006 and 2007 combined and is more than 25% of the $157BN of high-yield loan and bond defaults in 2008.

Hitting the dollar volume of defaults in two months that it used to take three to achieve puts us . . . well . . . I was going to say it but Jeffery Werbalowsky, co CEO of investment banking firm Houlihan Lokey Howard & Zukin beat me to it, “You do the math, we are in the midst of the greatest pool of defaulted debt we have ever seen.”

Enjoy the week.

Jim Delaney

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