The Merrill Lynch High Yield Master Index in September suffered its biggest monthly fall since its inception. It declined –6.42% during the month, taking its third-quarter fall to –6.07%, which in itself was the biggest such drop since the third quarter of 1990. In addition, the spread versus Treasuries at the end of September had widened to over 914 basis points and was the widest seen since the 974bp differential recorded in January 1991. Within the (global) high-yield sector there was an inverse correlation between total return and credit rating.
“In fact even before 11 September, things had over the course of the year been worsening for both equities and high-yield bonds,” says Insinger’s Alex van der Speld. “Prospects already looked bad and we believed they would worsen. The effect of the attacks has been to speed up the market’s realisation that conditions would get worse – what may have taken three to six months to price in has been telescoped into four or five days. We have witnessed a major and brutal repricing of risk, all across the globe.”
Although they had been nervous of the high-yield sector and had been cutting back on risk since December 2000, raising more cash during the short market rally in April and May and then again at the end of July, Van de Speld and his colleagues acknowledge an element of luck in the timing of their final move to reduce risk. “We had had a meeting on the Friday before the attacks at which we had agreed that things really could get worse, and had moved more defensive.”
Of course, the European high-yield market was in a very sorry state, even before the shocks. According to Schroder Salomon Smith Barney, the default rates for the European market had hit 11.35% by the middle of August. “This figure.” it says, “breaks down to a 4.6% default rate for industrials and a 13.2% rate for telecom/media, which equate to some of the worst figures recorded since the beginning of the high-yield market in the mid-1980s.”.
Prospects for recovery may not be that fair either, although there are opportunities out there. “Our market is so young, we believe that the magnitude of this shock could mean that its effects may take many, many months to wear off. Liquidity has dried up and it seems likely that issuance too will wane,” says Van der Speld. “Our clients are very scared of risk right now, especially when it comes to equities. But we are recommending that perhaps now is the time to be building, slowly and carefully, some stakes in the high yield sector.”
For its funds, Insinger have been ‘butterflying’ their risk exposure by, for example, cutting back on AAs and switching into a combination of government/supranational/AAA and a portion of high-yield. “W e’ll keep our overall risk exposure very low, but at the same time we can take advantage of some of the bargains available,” explains Van der Speld.
While advocating a very cautious stance and suggesting that investors should focus on companies with limited exposure to a recession, the team at SSSB agree that it may be safe to put some money to work in this market.
“Despite all the bad news, some good news is beginning to show in the telecoms sector, where we believe that most of the weakest names have been weeded out over the past year. Our analysis suggests the worst is over for the telecom and media sectors,” they argue. “And while we do not believe that the telecom meltdown is over, we do expect default rates in 2002 in this sector to be half of 2001’s peak. The second quarter of 2001 represented the nadir for the telecom/media sectors, which dominate the high-yield market, but it was only the beginning of defaults on the industrial side. To date we have seen an industrial default rate of 4.6% and our forecast for the year-end is as high as 5.7%, but that default rates for European high-yield credits as a whole should fall next year.”

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