Credit Markets Continue to Improve

Eric Takaha, CFA¹
Director of Corporates/High Yield
Franklin Templeton Global Fixed Income Group®

With the U.S. economy gradually emerging from recession, the fundamental credit environment for investment-grade corporate paper looks to be supportive heading into 2010, in our view. While we believe the rate of growth in the U.S. may be below what has been historically seen in a recovery following such a severe recession, moderate, rather than fast, growth is typically a more supportive environment for investment-grade credits as management teams tend to mind their balance sheets as much as they do more shareholder-friendly activity.

On the high-yield and leveraged-loan side, we have seen wide swings in spread levels over the past two years. Generally, though valuations tend to lead fundamentals, spreads and defaults move largely in line over time. This year was an exception, as the market was pricing in a default rate far superior to what it turned out to be, which helped drive exceptionally strong total return performance for both sectors. Over the past several months, default rates in the high-yield and leveraged-loan sectors have started to move lower again. Assuming the credit markets remain open and the economy posts at least moderate economic growth, we believe 2010 default rates may come down meaningfully from trailing twelve-month levels. In light of the expected decline in defaults, and valuations still somewhat cheap compared to historical averages, we continue to find value in non-investment-grade opportunities.

One negative factor weighing on bank loans and high yield is the approaching maturity of leveraged buyout loans launched in the middle part of this decade. They will need to be refinanced over the coming years. For investment-grade financial issuers, there is also a refinancing issue, as many banks in the U.S. and Europe took advantage of government financing to help with liquidity shortfalls at the height of the banking crisis. This government financing will also be approaching maturity over the next couple years, and markets could become jittery as banks are required to repeatedly tap the public markets to refinance these obligations.

Another long-term concern is the deteriorating quality of the non-investment-grade market. A spate of downgrades over the past year, combined with a significant proportion of lower-rated leveraged buyout-related issuances means average quality is toward the lowest level we have seen in that market, with approximately one quarter of the high-yield index rated CCC or below as of end-November, according to the Barclays Capital U.S. Corporate High-Yield Index. Over time this could lead to a higher level of defaults.

As for traditional government bonds, we have seen 10-year U.S. Treasury yields move up again of late, as risk aversion has given way to concerns about the government deficit and inflation. We believe the federal government's fiscal resolve and actions by the Federal Reserve may be crucial in determining how the Treasury market fares over the near term. However, given the potential for interest rate increases over the longer term, our strategy has been to reduce exposure to more interest-rate sensitive sectors, such as U.S. government bonds and agency mortgage-backed securities, while increasing exposure to certain global foreign-currency bonds. We continue to see significant opportunities outside the U.S., particularly in Asian markets, because of currency dynamics. While we also continue to have a heavy weighting in all kinds of credit-sector products, lately we have been shifting some of our focus away from investment grade and moving toward bank loans and high-yield paper, which we believe may also prove less sensitive to interest rate movements.

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Footnote
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