DWS junk chief: low defaults, healthy yields keep junk an attractive asset class

By Paul Deckelman

New York, July 20 - A year ago, the high yield market was surprising everybody by posting a year-to-date return of around 30% on its way to an eventual record high for the year approaching 60%. Fast forward a year, and things in Junkbondland have decidedly calmed down, with year-to-date returns on most major indexes currently in the 6%-7% area. But nobody at DWS Investments is singing the blues. Instead, the U.S. retail asset management business of German financial giant Deutsche Bank AG sees this year having unfolded pretty much as expected, with junk remaining a very attractive place for investors' money, especially when stacked up against such rivals as equities and Treasuries.

"We're certainly not going to go back to the returns of last year," acknowledged Gary A. Russell, managing director and head of high yield bond portfolio management at DWS. He told financial reporters at DWS' quarterly fixed-income press briefing and outlook session on Tuesday that "we thought this year would be a coupon-return, or coupon-plus return year - and that's what we're seeing."

Maybe that pales a little compared with last year's spectacular once-in-generation results - but Russell said that as things now stand, "it's a good coupon-clipping environment."

He pointed out that with 10-year Treasuries currently yielding around 2.90% - governments, he said, have "very low yields" - junk, on average, offers a considerably fatter yield of around 8.60%.

At the same time, volatility in the equity markets "has picked up, actually, while high yield is doing all right," with returns above 6% at this point "and nowhere near the volatility of equities."

On top of that - much to everyone's surprise - defaults, which hovered up around 12% on a 12-month trailing basis a year ago, have radically dwindled to just around 3% this year, "and everyone's expectations on a going-forward basis for one year is about 2%."

Put all of that together, Russell said, "and that's the story for high yield there."

Risks remain

The junk market is not without its risks, of course.

Russell said during his presentation that the macroeconomic world could still intrude and spoil the party should the economy slip into a double-dip recession, or even a deflationary situation. But while that's certainly a possibility, "it's not our main scenario - there are risks out there, but we do find [high yield] attractive."

The DWS managing director expects only slow growth in the current environment - but from a junk perspective, that's not necessarily a bad thing.

"On the macro[economic] side, you don't need 4% or 5% growth - you only need 2% or 3%, that is what we're talking about."

Likewise, he said, especially with companies now moving into the period when most of them are reporting earnings from the calendar second quarter - "the risk is more toward the equity side, where you need top-line growth to get the returns on equity you need, while within high yield, you don't need the big top-line growth, given what companies have done to improve margins and therefore cash flow," referring to the efforts by many issuers to aggressively de-leverage over the past several years.

"Companies were quite proactive in order to do that and set up that environment. I think they're benefitting from that from a bondholders' standpoint right now - we don't need the big top line to generate the returns.

"It's going to be interesting to see where the numbers are coming out this quarter."

Looking ahead

Russell believes that with BB bonds averaging around a 7% yield and single-Bs around 8½%, the junk market could see about another 50 basis points of spread tightening this year.

However, he thinks that a lot of that will likely not come from falling junk yields as prices rise. "The spread tightening is really going to be driven by what happens to the government bonds, whether you have an increase in rates or not. Even if you do get significant spread tightening, it's going to be coming more from that side, with rates increasing."

On the new issuance front, he pointed out that roughly one-third of the supply so far this year has been senior secured, "so you have a lot of bank debt being refinanced with bonds, given the problems you had earlier in the year with the bank loan market and the big demand you have in the high yield market."

And that trend is continuing - he pointed to Tuesday's big deal from Calpine Corp., which sold an upsized issue of $1 billion 10-year first-lien senior secured notes, with the Houston-based independent power producer having earmarked the proceeds to repay term loan debt.

While last year's new-issuance was largely done to repay, redeem or refinance debt of one kind or another, with just a mere handful of deals done to fund, say, mergers and acquisitions or leveraged buyouts, he said that this year there is some LBO financing as junk is "drifting toward a more bullish environment."

But he added the caveat that it's still a relatively small amount. "You're starting to see it - but that's compared with last year, when you had [virtually] none. You're starting to see some now, but I think the big focus is still on refinancing."

Cautious, Careful and Conservative

Another type of deal making a comeback this year after being largely absent from the market last year, Russell said, is borrowing by CCC rated companies, such as last week's $1 billion offering from Dutch semiconductor maker NXP BV - the first deal with CCC ratings from both major agencies in literally months.

"I think we've already seen an increase in CCC new issuance year-to-date," he declared, "whereas last year, it wasn't possible. We've certainly seen that open up, which I think is also leading the default rate forecasts even lower than what they are right now, because of the access to the market right now that companies have," letting them refinance and thus avoid becoming yet another defaulted credit.

"The market is open" for such deals, he added. "I think you're going to continue to see that, especially with the wall of debt that people are going to be addressing in 2014 and 2015."

But while there is more CCC paper coming on the market - as well as no shortage of already outstanding "triple-hook" bonds - Russell said that at DWS, "we're still selective on the CCCs - I don't think you should be buying things blindly, there's risk out there.

"We are cautious and selective."

Crazy about crossovers

At the other end of the high yield universe, those bonds just a notch below investment grade are proving attractive to many "crossover" high-grade investors reaching for yield, said another participant in Tuesday's briefing, John D. Ryan, a DWS director and manager of a number of its fixed-income portfolios, who said that the company "definitely" sees such crossover buying continuing.

"Some of our best-performing credits are in the crossover space. Even solidly in high yield, you have a lot of credits that have done a lot of good balance sheet moves, so they're in great shape for upgrades."

Ryan said that "we spend a lot of time looking at the crossover space for credits that are poised for upgrades. It's a great spot for investment because there's not any [further] value at the high-quality range, but they have a lot of [potential] downside." Meanwhile, "there's a lot of upside in the crossover space."

He said a lot of those crossover bonds "are actually fairly well known by investment grade investors because they were investment grade two years ago, then migrated down - and now some of them are set to come back."

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