The Global Bull Bets on High Yield Debt

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

Your current Global Bull Market Alert portfolio is carefully divided between both “bullish” and “bearish” positions. So despite global stock markets selling off toward the end of last week, your position in the the PowerShares DB Commodity Double Short ETN (DEE) and your short position in the iShares MSCI United Kingdom Index (EWU) both rose over the past week. As expected, your bullish positions — your bet on Millicom International (MICC) and the iShares MSCI Emerging Markets Index (EEM) — both ended the week lower.

This week’s Global Bull Market Alert pick, iShares iBoxx $ High Yield Corporate Bd (HYG), is a bet that the extreme risk aversion of investors toward corporate borrowers — specifically as reflected in the spreads between high yield debt and U.S. Treasuries — will abate over the coming months. And here’s why I expect HYG to generate double-digit percentage gains on the back of this shift in investors’ sentiment.

Corporate bonds were sold off with abandon when fear gripped global financial markets in October. But as with the sell-off in global stock markets, this was overdone. Even if the global economy will face enormous challenges in the coming year, corporate balance sheets remain healthier than the current spreads on corporate debt would indicate. Yes, high yield-default rates, which ran at just 3.4% in the past 12 months, are certain to spike in 2009. Moody’s Investors Service expects the U.S. high yield-default rate to top 10% in the next year. Barclays Capital is predicting a rate of 14.3% by the second half of 2009.

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But it is important to put these numbers into context. At the worst of the Great Depression — a 30% drop in GDP with 25% unemployment — only about 15% of issuers defaulted. And with a 20% average yield (compared with 9% at the start of 2008) even these extremely bearish scenarios are more than reflected in the price of corporate debt. According to Barron’s, the average high yield issue trades for less than 60 cents on the dollar. That means that defaults might have to run at a cumulative 50% rate in the next five years and recovery rates average just 30 cents on the dollar — versus a historical average of about 40 cents — for investors to get subpar returns.

Investors are slowly catching on. High yield bond spreads — the spread between high yield debt and “risk free” U.S. Treasuries — is already narrowing. Merrill Lynch’s high yield bond index gained more than 6% in December, the strongest monthly increase since 1991. Today, high yields are down to about 18% from 22.5% a month ago, and back to levels we saw before the U.S. Presidential election and the run on Citibank. Yet even after the recent rally, the spread between corporate bonds and Treasuries still is off the charts relative to their historical averages.

Finally, the high yield market declined about 27% in 2008 — its worst showing in the past 20 years. If history is any guide, 2009 should be better. Down years like 1990 often have been followed by big gains. Given the complex relationship between price and yield, it wouldn’t take much for high yield debt to return 20% in 2009.
So buy the iShares iBoxx $ High Yield Corporate Bd (HYG) at market today and place your initial stop at $62.90. If you want to play the options, I recommend the June $77 call options (HYGFY.X). Be careful, though. The liquidity in these options is very limited.

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Portfolio Update

iShares MSCI Emerging Markets Index (EEM) ended the week down after a sharp sell-off at the end of the week in global stock markets. Nevertheless, certain markets such as Brazil and Ireland ended the week up sharply even in the face of negative investor sentiment. The bullish case for emerging markets stocks is still firmly intact

Your short position in the CurrencyShares British Pound Sterling Trust (FXB) bounced back over the $1.50 mark this past week after hitting a six and half year low against the U.S dollar the previous week. The fundamentals of the U.K. economy continue to be weak, and the pressure on the British currency continues to be on the downside.

Your short position in the iShares MSCI United Kingdom Index (EWU) was slightly up this week, though the surprisingly strong recovery in the British pound sterling impaired the gains in the U.S. dollar-denominated ETF.

The PowerShares DB Commodity Double Short ETN (DEE) had a strong week as global stock markets sold off and the price of oil fell below $40. Like the Japanese yen, this position is designed to be a hedge against poor stock market performance.

Millicom International Cellular S.A. (MICC) broke to a high of $51.41 last week before falling back sharply on the market sell-off. This is exactly the way I’d expect this highly volatile stock to behave. The pullback is a good time to add to your position.

P.S. Markets and investors’ portfolios have taken a beating during the last few months. With a new president, a global economic downturn, U.S. recession, and $700 billion government bailout, investors are left wondering — is the worst behind us or is the other shoe about to drop? What do I do now? Making profitable investment decisions during these unprecedented times can be difficult if you do it alone. Attend the four most important days of the year in 2009, February 4-7, at the Gaylord Palms Resort and learn how the experts are finding profitable opportunities during the market crisis and how to position your portfolio for safety and growth. To register FREE, call 800/970-4355 and mention priority code 012653 or register online!

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