Fitch Outlook: Market Conditions Favor U.S. High Yield Market in the Near Term.

CHICAGO -- It seems safe to say that the high yield market has outperformed virtually everyone's expectations to date during 2006. As of Dec. 12, 2006, the year-to-date total return on the Merrill Lynch High Yield Master II Index (Master II Index) stands at an impressive 11.3%, or 12% on an annualized basis. According to Fitch Ratings, this strong performance came about as a number of market factors came together to create an accommodating environment for high yield.

Coming into 2006, the Federal Reserve Board (Fed) was intent on slowing the economy to avoid any inflationary spiral and was therefore in a rate hiking mode. The start of the year saw the Fed's target interest rate at 4.25% after 13 consecutive rate hikes at its Federal Open Market Committee (FOMC) meetings, and most market participants expected the Fed to continue to move its interest rate targets higher. Indeed, the Fed went on to increase rates another 25 basis points (bps) at each of its next four meetings in 2006 with its last increase to 5.25% on June 29, 2006. Since that meeting the Fed has held target rates steady and has stated that any future rate actions would be 'data dependent'.

Despite all of the increases in short-term interest rates, long-term interest rates are actually very close to where they began the year with the benchmark 10-year Treasury yielding 4.49% as of Dec. 12, 2006, compared to 4.39% at the end of 2005. This relatively benign long-term interest rate environment has certainly been a benefit to fixed income investors, including high yield. As the year progressed, investors seemed to reach the consensus that the Fed had engineered a healthy environment for high yield - an economy that was slowing enough to lessen inflation concerns but not slowing so much as to raise the specter of declining corporate profitability. In addition, there was significant liquidity in the high yield and leveraged loan markets as investors looked to spread products for investment returns. This helped to create a very positive supply/demand dynamic.

Finally, the relatively strong economy and significant liquidity available within the bank loan market contributed to the very low default rate. The trailing 12-month default rate through November stood at only 2.0% (and only 0.7% year-to-date), well below the 1980-2005 average of 5.3%. In some ways the low default rate is somewhat self-perpetuating in that low defaults have made high yield an attractive asset class which has in turn increased liquidity, making it possible for companies that need money to access the market.

While virtually all industry sectors in the high yield market performed well in 2006, the sectors that were the most distressed coming into 2006 provided investors with the most impressive returns. After being the two worst performing sectors in the Master II Index in 2005 (each declining over 10%), the auto and airline sectors have rewarded investors willing to delve into these distressed sectors. Through the third quarter of 2006, the auto sector had returned 17.1% and the airline sector 16.4%.

The Fed Takes a Break

Beginning with its Aug. 8, 2006 meeting, the FOMC has maintained its target for the federal funds rate at 5.25%. This followed 17 straight 25 basis point increases in the target rate dating back to June of 2004, which were intended to slow the economy enough to ensure that inflation remained in check. In its press release on Dec. 12, 2006, the FOMC reiterated that economic growth has slowed as result of the cooling of the housing market, and inflation remains a concern. They noted, however, that inflation pressures seemed likely to moderate over time, reflecting reduced impetus form energy prices, contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand. Even so, the FOMC noted that some inflation risks persist and that future target interest rate actions would continue to depend on incoming economic data.

In the minutes of its Oct. 24-25, 2006 meeting, the FOMC staff economic forecast predicted a gradual reduction of the contraction in residential investment and further gains in consumer and business spending going forward. According to the FOMC, this should to lead to a pickup in GDP growth in 2007 and 2008, albeit at a slower rate than in 2006. This slower growth would result in part from less impetus from household wealth, interest rates and fiscal policy.

An Economic Soft Landing?

According to the Bureau of Economic Analysis (BEA), the U.S. economy grew at an annual rate of 2.2% during the third quarter of 2006 as measured by the increase in gross domestic product (GDP). Although this figure was recently adjusted upward from an earlier preliminary estimate of 1.6%, it reflects a continued deceleration in U.S. economic growth during 2006 following increases of 5.6% in the first quarter and 2.6% in the second quarter. The BEA identified the causes of the slowdown in GDP growth as a combination of a decrease in residential investment, acceleration in imports, and decelerations in inventory investment, consumer spending for services and government spending at the state and local levels.

Most economists are predicting that although growth is slowing, the U.S. economy is likely heading towards a 'soft landing,' loosely defined as period when GDP growth is low enough to avoid accelerating inflation but still positive. Given historical experience, soft landings would seem to be the exception rather than the rule. Even so, the Council of Economic Advisors currently estimates real GDP growth of 3.1% in 2006, slowing to only 2.9% in 2007. Current consensus estimates for real GDP growth in 2007 average approximately 2.5%. Clearly these forecasts would indicate that general expectations currently favor the soft landing scenario, although exogenous factors, such as war or natural disasters, continue to be a risk.

Fitch recently released its outlook for the global economy (see Fitch's 'Global Economic Outlook,' dated Nov. 25, 2006). One of the key conclusions in the report is that the U.S. economy will slow following the adjustment in the housing sector as wider consumer spending softens during the first half of 2007. Even so, Fitch anticipates only a marginal slowdown in consumer spending over the next six to nine months to an annualized growth rate of about 2%, well short of a major retrenchment. Fitch also believes that slower economic growth and declining energy prices will help offset recent upward pressures on core inflation, causing the Fed to hold off on raising interest rate targets any further. Fitch currently anticipates U.S. economic growth of 3.2% for the full year 2006, declining to 2.4% in 2007.

High Yield Market Outlook

As 2006 winds to a close, market conditions appear to favor continued improvement in the high yield market, at least in the near term. Despite consistent interest rate increases by the Fed, the cost of capital remains relatively low by historical standards. With the recent pause in rate hikes by the Fed, interest rates have begun to stabilize and even decline. Energy prices are beginning to fall and inflation appears to be in check. In addition, liquidity is at record high levels with the increase in market participation by hedge funds and structured vehicles. Unlike most previous periods when the U.S. was entering an economic slowdown, high yield companies are flush with cash and have generally improved their balance sheet by either reducing debt levels and/or extending maturities. Default rates are near historical lows and recovery rates (defined as the average trading level of bonds 30 days after default) are at record highs at nearly 75%.

So what could go wrong? Plenty. As historical returns have shown, although the risk/reward trade-off (as measured by the Sharpe Ratio) for high yield bonds is among the best of the various capital market instruments, the volatility of those returns is significant. Despite current market complacency, the risks appear to be rising. New issue quality is deteriorating as evidenced by the high level of lower rated issues and the downward rating migration of recent LBO transactions. In addition, improvement in corporate financial metrics is slowing, covenant packages are weakening and aggregate debt maturities are rising.

Other risk factors in this credit cycle include the high levels of senior secured debt (leveraged loans) issued by speculative grade companies, which could result in little value accruing to unsecured creditors in the event of default, and the huge increase in foreign investment in U.S. debt securities, which would have a decidedly negative impact if withdrawn. External event risk will also remain a major concern for high yield investors in 2007, particularly as the U.S. situation in Iraq worsens and the threat of terrorist activity remains high. Significant unknown factors in the current credit cycle include the rapid recent growth of the credit derivatives market, which now exceeds the size of the cash market; recent changes in U.S. bankruptcy laws; and the proliferation of collateralized loan obligations, hedge funds and structured vehicles. In addition, large capital flows into private equity funds continue to drive their appetite for increasingly large and risky acquisitions.

Fitch believes that high yield market participants could expect to earn their coupon (the yield-to-worst on the Master II Index is presently about 7.70%) over the next year if the economic soft landing scenario materializes. But this is probably about the most they should expect. As of Dec. 12, 2006 the option adjusted spread on the Master II Index stood at 306 bps, near the record low spread of 271 bps set on March 9, 2005. Such a tight spread over U.S. Treasuries would appear to limit the price upside of high yield bonds during 2007, barring an unexpected rally in the U.S. Treasury market. Given that price is a key component of bond performance, this would in turn limit total return. On the downside, if the economy slows more than expected or if a significant exogenous negative event occurs, the total return for the high yield market could be significantly lower than that experienced in 2006.

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