Eye on the Market I November 19, 2012 J.P.Morgan A case-dependent Thanksgiving for investors: credit, portfolio investing, cash, Congress, Iran and your blood pressure Be thankful for the Fed, if you invest in credit You should be thankful for the Federal Reserve if you invest in credit. By reducing rates to zero, the Fed unleashed a wave of interest in a variety of credit products: high grade bonds, high yield, leveraged loans, municipals, asset-backed securities, mezzanine debt, other private credit and distressed debt. So far this year, distressed debt is at or near the top of the hedge fund total return tables I have seen; as shown in the III chart, the universe of high yield bonds and loans trading below a dollar price of 80 has declined again as the rising tide in credit has lifted all boats. Among the distressed debt winners in 2012: recoveries after liquidation (Lehman, MF Global); converted equity stakes obtained during a Chapter 11 reorg (Capmark, Delphi); and debt gains after a restructuring that avoided bankruptcy (Realogy, Clear Channel, MGM). Corporate cash flow is generally in good shape, so the rally in spreads seems reasonable. In addition, the "quality" of the new issue market has been stable (20%-30% of all high yield issuance was rated B- or lower in 2011 and 2012, compared to 40%-60% during the credit bubble). However, given the rally in spreads, it looks like investors are in for carry instead of capital gains. In addition, while global and US default rates are low, they have already bottomed (2nd chart), and are expected to tick up by 0.5% or so in 2013. As a result, while we have been aggressive advocates of credit positions since the fall of 2008, return expectations have come down. US HY bonds and loans trading <= 80% of face value Percent 50% Peak levels f Nov. '08) 45% Bonds: 77% 40% Bonds Loans: 81% 35% 30% 25% 20% 15% 10% 5% 0% 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: J.P. Morgan Securitie