Thursday, October 22, 2009

A recovery theory rooted in junk bonds

Consider the following news bits:
* S&P lowers bond default forecast
Standard & Poor's said on Wednesday it lowered its forecast bond default rate to 6.9% for the next 12 months, citing better access of low-rated companies to funding and less volatility in the market. The rating agency previous expected the default rate to rise to 10.8%. "The marked improvement in financial conditions has altered our expectations for corporate default rates, analysts led by Diane Vazza wrote in a research note. "The sharp decline in funding costs, the reopening of the bond markets (even for low-rated issuance)" and less volatility will lower the cost of refinancing, they said. Also, the firm now expects some defaults to be pushed out later than its forecast horizon, instead of occurring in the second half of 2010, S&P said. The gap between what speculative-rated companies have to pay to sell debt and Treasury yields has declined to levels last seen in mid-2008, Vazza said.

* Is This a Real Bull or "Red Bull" Market?
* Why Junk Bond ETFs Are Calling to Investors

So here's my theory: Despite a really amazing bull market in the junk bonds, the fundamental driving it has just gotten even better - the rating agencies predicting lower default levels. This should allow the junk bond ETF-s to appreciate even further. The side effect (or the cause - depending on point of view) - would be lower yield. As a result, more large scale companies with medium to good credit could refinance and even expand their leverage. Using that leverage they would replenish inventories, which would reignite another growth cycle in the economy. This should lead to lower unemployment (at some point). At the very hint of unemployment subduing
two things should happen. One - the stock market would recognize this extremely bullish indicator and shoot up. Two - people would start spending more. And at that point, inflation/higher federal rates should restart.

Well... that's my bullish take on it. There are plenty short term and political perspectives which should suggest failure of recovery and further collapse. What do I know? I'm just a guy who tries to extrapolate from what he's reading.


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