Douglas Forsyth

NACM

Recent optimism over slower economic contraction has spurred a rebound in beaten up bonds, creating potential opportunities for investors seeking a mix of income and total return.

An unprecedented level of government stimulus and improving economic data have helped credit markets rally in recent months after having been decimated by the fallout from last year’s housing collapse. As a result, investor attitudes toward risk have turned less negative and money has been flowing into high-yield bonds and convertible securities.

Indeed, U.S. companies raised $7.55 billion in high-yield bonds in the first full week of May, representing the largest amount of new issues to come to market since June 2008 when investors plowed $9.1 billion into new junk bonds, according to fixed-income tracker Dealogic.

“The entire capital markets have reopened for high yield and convertible bonds,” said Douglas Forsyth, managing director and senior portfolio manager at Nicholas Applegate Capital Management (NACM), on a recent conference call with financial advisors. Year-to-date there has been nearly $20 billion of new issuance from high-yield issuers. And the convertible market – although quiet in January and February – has also reopened with over $6 billion in new issuance year to date. Much of the recent appeal stems from the double-digit returns these riskier bonds have been generating of late.

The Merrill Lynch U.S. High-Yield Bond Index posted an 11.47% gain in April, the biggest one-month return in its 22-year history. In October 2008, the index experienced its worst-ever decline, plummeting 16.30% in the wake of the Lehman Brothers collapse.

“April has produced record returns in the high-yield market and near-record returns in the convertible market looking back to 1999,” Forsyth said. “We are seeing incredible opportunities in the secondary markets where we can get extensive yield opportunity and total return plays in both the high yield and convertible space.” In the secondary market, securities are sold by and transferred from one investor to another.

Despite the recent bout of optimism surrounding these asset classes, the economy is still mired in the doldrums, which could pose a threat to a sustainable credit rally. “We may print negative employment figures for the next three to six months. We may have negative GDP for another quarter,” Forsyth said. “But that doesn’t mean that the forecast for how these securities are going to trade is going to decline from here.What we’re seeing is a fundamental shift – the credit markets opening back up.”

Looking back on 2008, the collapse of the housing market caused major dislocations in mortgages, structured products and other debt securities as buyers dried up and the appetite for risk evaporated, Forsyth said. From a fundamental standpoint, however, many issuers in the high yield and convertible bond market were not affected. “Initially all of the selling was technical,” he said. Eventually, bank loans sold off and structured products unwound, which spurred high-yield bonds to be negatively impacted, in turn, causing spreads to widen dramatically.

Forsyth, lead manager of the Allianz NACM Income & Growth Fund, noted that credit spreads have tightened in the first few months of 2009, reversing last year’s trend of historically wide spreads in corporate bonds. In December, high-yield corporate bond spreads grew to 23% over relevant Treasuries and have since dropped to roughly 13% – although still considered high by historical standards, he said.

Still, a tenuous economic outlook and an aversion to risk have tempered optimism for high-yield bonds and convertibles. Forsyth contends that this offers the potential for more upside going forward. “The opportunity set is definitely not behind us,” Forsyth said on the call. “There are still so many participants that are fearful of the credit markets and what might be the case for defaults.”

High-yield bonds, or junk bonds, are at the lower end of the credit spectrum meaning there is a greater risk of default, a scenario in which the issuer doesn’t meet its interest obligations or is unable to return capital to investors. Given the default risk inherent in this asset class, issuers need to offer a higher income stream to make them attractive.

Still, Forsyth believes that the threat of defaults has been overestimated. Between 1992 and 2002, the default rate for the high-yield market peaked on a trailing 12-month basis at approximately 12%, he said. Pacing that default rate were the lowest quality issuers – the CCC issuers – in the high yield market and those levels were reached in very different times and circumstances. To reach a 23% spread over Treasuries there must be “incredible technical pressures,” he said. However, there also must be an expectation and occurrence of defaults to widen out those spreads so dramatically, he added.

In an effort mitigate default risk in the portfolio, Forsyth avoids CCC issuers or those currently susceptible to default. “CCC issuers have participated in three of the last 16 years of performance in the high yield market. Rather, we look for higher quality names, the highest visibility companies, those that have the best exposure to industries that are likely to be successful regardless of the economic environment,” he said on the call.

"We do not believe that defaults will surpass prior cycle highs," Forsyth said. “The reason is that the concentration in industries is not as high as it was in the last cycle. Between 1999 and 2002, 42% of the high-yield market was comprised of technology, media and telecommunications issuers. Many of these names were widely held, particularly Worldcom, which had multiple billion dollar market caps that the market peaked only to default and return nothing to bond holders. Their balance sheets had no tangible value.”

Today, there are very few industries that even have a 10% weighting in the benchmark and therefore very few issuers can have an overall macro effect on the entire high yield market, Forsyth said. “Without the industry concentration it’s unlikely that we’re going to experience broad reaching defaults intra linked from relative industry failure.”

Forsyth, along with managers Justin Kass and Michael Yee, employ a bottom up approach and conduct extensive credit research to invest in three distinct sleeves: convertible bonds, high-yield bonds and large-cap stocks. The combination of these securities is designed to reduce volatility while providing multiple sources if income and capital appreciation.

Convertible bonds are more of a hybrid investment than the other sleeves, combining the steady yield of bonds and the capital appreciation potential of stocks. Companies that issue convertibles agree to pay holders a fixed yield, while simultaneously allowing investors the option to exchange the bonds for a certain number of shares.