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High yield corporate bonds
Preference: overweight

UBS View
Spread USD HY (24 Oct): 540bps (last month: 573bps)
USD HY spread target (6-month): 475bps
• We reiterate our spread target of 475bps based on still robust corporate fundamentals, a favorable technical backdrop and the commitment of major central banks to provide strong monetary support. In particular, the Fed's buying of mortgage-backed securities (MBS) is likely to provide further support for the credit universe.
• Thus, US high yield (HY) bonds continue to offer attractive value although spreads tightened considerably in Q3. We think the recent rally has been justified in light of the favorable default outlook and central bank action. The ongoing slow recovery of the US economy, healthy company balance sheets, robust earnings, and strong investor appetite for yield assets continue to push spreads lower. US HY thus remains our preferred asset class.
• Despite the recent uptick in defaults, in the absence of a renewed US recession, we expect the default rate to remain stable at 3.5% until the end of the year. A heavy load of new issuance so far this 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).

Positive scenario
USD HY spread target (6-month): 400bps
• Even in the positive economic scenario, spreads are unlikely to tighten to pre-crisis lows of below 300bps due to lower liquidity and a generally higher risk premium after the financial crisis. Benchmark yields would rise, limiting HY returns to around 7%. European HY outperforms the US.

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

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 increasing proportion of peripheral and financial issuers in the European HY universe and the poorer economic outlook in Europe.
• Inflows into HY mutual funds have been strong so far in 2012. New issuance was strong in Q3.

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 both relative to other fixed income and for absolute return-oriented investors.

Yield spreads
[Chart showing yield spreads in bps from 2005 to 2012, comparing EUR High Yield and USD High Yield]
Source: Bloomberg, UBS, as of 16 Oct 2012
Note: Past performance is not an indication of future returns.

What we're watching
Credit quality/default cycle
Why it matters
US earnings were roughly flat in 2Q compared to 1Q. A modest pickup is expected in 2H. Balance sheets are backed by high cash levels and low debt ratios. Against this backdrop the default rate will likely remain below its 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 further in early 3Q. Key dates: late October, US Fed Senior Loan Officer Survey

UBS
For further information please contact CIO's asset class specialist Philipp Schöttler, philipp.schoettler@ubs.com
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Please see important disclaimer and disclosures at the end of the document.
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