A rock and a hard place. Rocky terrain. Peaks and plateaus.
Bank of America has released its 2009 credit outlook — and it’s surprisingly geological in its main theme. The title: Matterhorn vs. Ayers Rock.
The credit version of the above pics is in Figure 7 below.
Put simply, they’re debating the depth — and structure — of the credit cycle. Specifically, whether we’ll see a ‘classical’ version of accelerating defaults followed by rapid improvement (the Matterhorn) or an Ayers Rock scenario, in which government intervention to stave off bankruptcy ends up prolonging the credit adjustment. So which exactly, should we be hoping for? BoA’s credit team has this to say (emphasis our own):
Investing before the peak of defaults in the past 2 cycles resulted in high Yield returns of 45% in 1991 and 28% in 2003. Those returns are a consequence of allowing bankruptcy to clean out future default uncertainty, resulting in better quality companies surviving and a reduction in the cost of credit and an improvement in its availability… Despite its headline figure of 30% cumulative default rates across 2009-11, the “Matterhorn” scenario should be hoped for as the economic implication of “Ayers Rock” increases cumulative defaults to 50%.
The historical perspective suggests that Matterhorns are much more likely than Ayers Rocks — but, then again, we’ve never seen government intervention on this scale before (at least, not in the latter half of the twentieth century — which is about as far back as the FT Alphaville team memory goes). We’d also note that a prime criticism of quantitative easing in Japan was that it ended up postponing the structural change that many argued was necessary for the country’s banking system. That the US is embarking on something similar could end up tilting the balance in favour of an Ayers Rock situation.
In any case, a major clue as to which of these mountains we’re heading for will be whether the US government ends up bailing out the country’s auto industry, BoA says (the UK, incidentally, is also reportedly considering such a measure). Liquidity, the ability to refinance credit, will also play a key role. In fact, as BoA notes:
Abrupt withdrawal of credit is the key factor that distinguishes the current default cycle from those in the past…
So which one of the above scenarios is Bank of America itself expecting?
They’re not sure, they seem to be preparing for both — and a range of them at that (Figure 29 below):
In three Matterhorn scenarios we assume financial markets are back to normal in five years and thus the pricing of the hypothetical portfolio at the end of five years returns to close to par.8 Under the Ayers Rock scenario we assume no improvements in the credit markets consistent with that scenarios protracted default cycle, and hence prices at the end of five years remain unchanged.
Note that under all the “Matterhorn” scenarios, both loans and bonds project relatively attractive returns of 15-20%. However, those returns collapse to under 10% in the “Ayers Rock” scenario. Our uncertainty as to which scenario ultimately occurs provides another reason to hold off at the beginning of 2009 towards a greater allocation to leveraged finance in either loans or bonds.
Overall though, BoA’s credit team, perhaps unsuprisingly, are maintaining that fixed income will trump equity in terms of returns next year.
At the highest yields in a decade, high grade corporate bonds yield over 8%, offering a competitive return to equity with lower risk. Following stocks’ 40% decline and substantial volatility, reduction to over-allocations in equity may provide a key source of support for credit returns in 2009. Our recommendations favor a high quality portfolio as default risk in leveraged finance keeps us waiting for more clarity on the emerging credit cycle before venturing into the more tempting 22% levels offered in high yield.
A caveat here, from BoA’s humble review of its 2008 Alpha strategies:
Editors Note: Ending the year, we are closing out all of our remaining “alpha” portfolio trade recommendations. We’ve had a mixed year of results, and the tables below highlight the good, the bad and the ugly. Generally we found our initial recommendations were good, but our willingness and ability to exit profitable trades reflected a lack of discipline and consistent distraction inherent in our macro strategy role. We’ll return next year with a new set of “alpha” portfolio recommendations…
Oh dear. We still think this BoA note rocks though. (Sorry).
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