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High yield corporate bonds
Preference: overweight

UBS View
Spread USD HY (26 June): 660bps (last month: 660bps)
USD HY spread target (6-month): 525bps

• US high yield (HY) bonds continue to offer attractive value; we expect high single-digit total returns over the next six months. We stick to our spread forecast of 525bps based on an ongoing recovery of the US economy, robust company balance sheets, rising earnings, and ongoing investor appetite for higher-yielding assets. US HY bonds remain our preferred asset class.
• Fundamental factors remain supportive. Despite the recent uptick in defaults, in the absence of a renewed US recession only a very gradual increase is to be expected. We forecast a modest rise in the trailing default rate to 3.5% at the end of the year from 3.1% in May. A heavy load of new issuance in the first three months of the year means that HY companies will be faced with a lower risk of failed refinancing going forward (e.g. in case of an unexpected economic slump).
• We acknowledge that ongoing risk aversion could still cause spreads to widen somewhat in the short run. Investors who are able and willing to hold on to their HY position will likely benefit over 6 months.

Positive scenario
USD HY spread target (6-month): 450bps
• In the positive economic scenario, a rally in high yield bonds and a return to pre-crisis spreads of about 400bps is likely. Benchmark yields would also rise, limiting HY returns to around 10%. European HY outperforms the US.

Negative scenario
USD HY spread target (6-month): 1,200bps
• A global recession is a major risk for high yield bonds. Based on the more robust state of the corporate sector, we would not expect spreads to widen to 2008/09 peak levels above 2,000bps. Although short-term spikes are likely, due to liquidity suddenly drying up, we would expect a quick return to the "usual" recession-level spread of around 1,200bps.
Note: Scenarios refer to global economic scenarios (see slide 7)

What we're watching Why it matters
Credit quality/ default cycle As long as corporate earnings increase and balance sheets remain backed by high cash levels and low debt ratios, the default rate will remain below its 5% long-term average.
New issuance For now, favorable conditions in the primary market have mainly been used for refinancing. More aggressive issuance activities should be monitored.
Bank lending standards Bank lending provides an important source of funding. US banks relaxed standards slightly in 2Q. Key dates: early-July, ECB bank lending survey; late-July, Fed Senior Loan Officer Survey

Recommendations
Tactical (6 months)
• US high yield corporate bonds offer an attractive return outlook and should be overweighted.
• We prefer US over European issuers given the poorer economic outlook in Europe and the increasing proportion of peripheral and financial issuers in the European HY universe.
• Inflows into HY mutual funds have been strong so far in 2012, but new issuance has cooled down a bit in April and May.

Strategic (1 to 2 years)
• We expect US defaults to remain at below-average levels for longer. Significant re-leveraging is unlikely in the medium term.
• We believe US high yield corporate bonds will provide good returns for absolute return-oriented investors, as well as relative to other fixed income segments.

Yield spreads
[Chart: bps 0-2500, Years 2005-2012, EUR High Yield vs USD High Yield]

UBS
Source: Bloomberg, UBS CIO, as of 26 June 2012
Note: Past performance is not an indication of future returns.
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For further information please contact CIO's asset class specialist Philipp Schöttler, philipp.schoettler@ubs.com
Please see important disclaimer and disclosures at the end of the document.
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