JPMorgan's Acciavatti sees further spread widening, escalating defaults; likes BB bonds, leveraged loans

By Paul Deckelman

New York, June 11 - "We are not out of the woods yet."

That was the warning from Peter Acciavatti, managing director and head of high yield strategy at J.P. Morgan Chase & Co., who said that despite the recent upturn seen in the high yield market, the rough period, marked by intense spread widening, is by no means past.

"We remain cautious," he told a meeting of the New York Society of Security Analysts on Wednesday.

While there has been something of a rebound seen in the junk and leveraged loan markets since about mid-March, he cautioned, "especially for high yield, we probably overshot."

The rally, he cautioned, probably went on for too long," and we could see "a return to some of the volatility we saw in the previous nine months."

Taking a look at the macroeconomic environment, Acciavatti opined that while the danger of a depression or a deep recession seems to have passed, the economy is likely to just "muddle along" in the near term, with housing problems continuing for at least another year or two.

He pointed out that despite moves by the Federal Reserve to lower interest rates since last summer, consumer lending rates for things like mortgages and auto loans have gone up during that time, as banks have tightened, rather than loosened, their lending, so the Fed action "has not had the intended effect of lowering [consumer] lending costs" as rate reductions have in the past.

He said consumers remain worried because their net worth has been going down, with the decline in house prices that he believes is only about halfway done, and the reduced availability of home equity and other formerly easy, convenient and cheap forms of credit. "We are coming off of easy money conditions for the last couple of years."

The J.P. Morgan managing director further said that banks - which have already written down over $300 billion of loans since the middle of last summer, are likely to face considerable additional writedowns.

Defaults to accelerate

This outlook for continued pain in the banking system mirrors the likely sustained upturn in defaults in both the junk bond and the leveraged loan markets.

Acciavatti said that junk has seen 13 defaults so far this year, versus just 10 for all of last year. In the loan market, the discrepancy is even more striking - 26 defaults so far this year versus just three for all of last year. He explained that the level of defaults was higher in the loan market because "there was more risk-taking in the loan market" - some borrowers who were going to access both the junk and loan markets frequently would elect to just do a bank deal and eliminate the junk tranche altogether.

Bad as it is, the trend of rising defaults will only accelerate over the next year or so - J.P. Morgan is expecting a year-end default rate of about 2.25% this year, 6.50% next year and a continued rise to an eventual peak - the level of which he did not predict - in 2010.

'Substantially' wider spreads

He noted that from the historic low spread levels reached around the middle of last year, junk and loan spreads had ballooned out by over 500 basis points to the peak levels seen earlier this year. Although there has been some pullback from those peak levels, bringing junk back down somewhat to current levels around 650 bps over Treasuries, that probably won't last.

Noting recent hopeful predictions that the worst may be behind us, he declared that "with an economy that seems to be better than expected, although it's certainly not great, and with stocks holding kind of holding in there, high yield may move sideways for a while - but we expect to see substantially wider spreads over the next six to 12 months."

He said that anticipating a rise in default rates to the 6.50% level that J.P. Morgan sees as likely for next year, as well as a projected default recovery rate below the historical average of about 35% - it could be more like 25% - implies a spread of about 861 bps, so "we're nearly 200 bps overvalued."

Acciavatti said that investors should wait until average junk spreads reach about 800 bps before really moving into high yield. He said that an investor might begin "averaging in slowly" when spreads go above 700 bps, but should not plunge in at that point.

"The risk is if you move in too early and you think you're going to have a quick turnaround for the broader markets," but should such a turnaround not materialize - here he cited a historical example from the fall of 2000 - not only will the investor's one-year return suffer, but the average two- and three-year returns as well.

Overweight BB bonds, loans

Within the junk category, he is advising investors to "trade up in asset quality" and give up a little yield in order to be positioned for a continued rising default rate. He recommends that investors underweight CCC rated bonds - lower-tier bonds, he stated "are overvalued" - give a market weighting to B-rated paper, but overweight BB rated bonds, as well as bank loans that are concurrently issued with high yield.

He also believes that especially when matched against high yield, leveraged loans represent "an attractive value."

Even having come in somewhat from the peak levels they hit earlier in the year, the current spreads of about 520 bps, using a 2009 year-end default forecast of 4%, appear cheap.

Even raising the default forecast to Morgan's predicted 6.50% still indicates undervalued spreads. However, Acciavatti cautioned, "not all loans are created equal," given the proliferation in recent years of second-lien tranches and other loans that aren't quite the equal of senior debt. "Credit selection in the loan market will be far more important than it ever was before."

Aaron Hochman-Zimmerman contributed to this report

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