Default rates peaked in 1991’s third quarter at 13%. By that time investors had already captured 12-month returns exceeding 30% (wsj 6/21/01). Default rates peaked again in January 2002 at 10.68%(and remained above 10% through July while the economy was still weak). The trailing rate was down to 7% during the 4th quarter of 2003; meanwhile, the high yield universe had returned 30% for the twelve months ended September, 2003.

In 1902 Charles Dow noted “There is always a disposition in people’s minds to think that existing conditions will be permanent. When the market is down and dull, it is hard to make people believe this is a prelude to a period of activity and advance. When prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which are unlike its predecessors and give assurance of permanency. The one fact pertaining to all conditions is that they will change.”

Now that the universe has once again provided equity-type returns, we draw attention to the fact that Caa and lower quality credits have produced over 90% of all defaults in past market cycles. Moreover, within 24-36 months after spikes in the volume of newly issued high yield debt, default rates begin to rise appreciably. Calendar 2007 saw over $140 billion of new issuance, a new record for domestic issuance. Additionally, $700 billion in high yield bank loans were completed. We are, therefore, cautious with respect to the lower quality segment of the high yield market and believe that current returns in that sector do no compensate the investor for the level of risk.

Our performance in the last down markets (1990, 2000-2002 and 2008) was excellent. In 1990, we posted a –1.3%(net of fees), 0.59% (gross) return while the Barclays Index was –9.59%, the Lipper High-yield Bond Mutual Fund Average was –11.08%, the S&P 500 was –3.17% and small cap stocks were –21.56%. Investors who were patient were amply rewarded in our conservative high-yield bond program with a return of over 29% in 1991, over 14% in 1992 and over 18% in 1993. During the 2000-2002 period, we provided a cumulative return of 13.62% while the Barclays Index was -2.28%, Lipper High-yield Bond Mutual Fund average was -8.66% and the S&P 500 was -37.64%. Finally, during the extraordinary difficult 2008 market, our return was -19.26% while the Barclays Index was -26.16 and the Lipper Mutual Fund Averages was -26.48%. The S&P 500 was -37.67% for 2008.

At 12/31/09, yield available in the “upper tier” of high yield market is attractive relative to other fixed income categories. In an improving economy, the BB and B issuers have the opportunity to improve credit quality, resulting in favorable returns for the investor.

Buying into this market now may represent a prudent move for the equity investor in search of value. Given recent advances, the S&P 500 trades at 20 times trailing earnings. (Barron’s 1/6/10) This is no bargain considering the long-term post World War II average of 15 times. Fairly valued sectors (better quality High-yield Bonds?) could be considered as less risky than overvalued sectors (equities?).