US Treasurys

Don’t Exit US Junk Bond Trade: UBS

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Recent reports of prominent investors shying away from junk bonds have intensified the debate of whether 2013 will be another year of outperformance for the much sought after asset class. High yield issuance reached a record $366 billion last year, and has topped $50 billion already in 2013, according to UBS Wealth Management.

The Financial Times reported on Thursday that major investors like Apollo Global Management, Oaktree Capital and GSO pared their bets on high yield paper late in 2012 and have even taken on short positions, fearing that yields will spike.

Weighing in on the debate, UBS' wealth management unit says – contrary to those major investors - it is not jumping on the bandwagon and abandoning the high yield credit trade. UBS says its outlook for high yield remains favorable and it sees returns of around 6 percent over the next six months.

"First, the valuation is attractive. U.S. high yield has a spread of 506 bps over U.S. Treasurys, and we expect a tightening over the next six months to 450 bps. While a return to pre-crisis lows of below 300 bps is unlikely, we mustn't underestimate the commitment of central banks to providing monetary support. Their actions will continue to force investors to "hunt for yield," a backdrop that should support the asset class," the group said in a memo sent to CNBC.

(Read More: Junk Bonds: Best in Class or Dangerous Bubble?)

UBS Wealth Management CIO Alex Friedman and Head of Investment Mark Haefele point to a second reason not to exit the U.S. junk bond trade, arguing that the rate of default for U.S. high yield issuers at the end of 2012 was at only 1.5 percent, well below the average for the past 30 years of 4.5 percent.

Rating agencies have been split on the outlook for a U.S. default. Moody's said in a report this week that overall U.S. default rates will have fallen from 3 percent this January to 2.7 percent by the end of 2013. In 2012, the rate increased from 2.3 percent to 3.3 percent. S&P however forecasts U.S. defaults will increase by 0.8 percent to 3.4 percent by the end of this year.

According to UBS, a third reason to invest in U.S. high yield is :"Issuer quality remains sound with less than 20 percent of newly issued bonds rated CCC or lower, relative to c.35 percent in 2007. And we expect to see GDP growth in the U.S. this year between 2 and 3 percent, which, while subpar, is perfect for credit." Friedman and Haefele add that they see no significant increase in net leverage.

High yield bond investors are at risk of losses under two scenarios: If investors are more optimistic about growth prospects, Treasury yields increase, making investments in high yield bonds less attractive. Conversely, if the economy weakens, spreads between high yield bonds and benchmark bonds widen.

(Read More: Morici: Uncle Sam's 'F' Rated Bonds)

Responding to the these concerns, UBS argues: "Though perfectly logical, the argument falsely assumes that the global economy is a binary system. The U.S. has not experienced a recession since the 2008-09 crisis, but growth remains relatively weak. This is an ideal environment for credit: growth is too low to force benchmark yields up, yet high enough to prevent defaults. Furthermore, if investors are concerned about benchmark interest rate risk, they can easily hedge it."

So when is the right time to exit the U.S. high yield trade? "Specifically, declining credit spreads are leading indicators of future equity returns, so if high yield spreads approached our 450 bps target we would likely shift all or part of our high yield overweight into equities, continuing the move we began in early January. Equally, were the macroeconomic outlook to deteriorate markedly we would likely remove our overweight position," UBS said.

The past week though has seen a slowdown in primary market activity in U.S. high yield. By Thursday afternoon only 7 U.S. issuers had tapped the market for nearly $4 billion. Insiders blame this lull on most issuers having tapped the market late last year and early January. However, Berkshire Hathaway and 3G's $28 billion acquisition of Heinz, announced on Thursday, may provide additional supply as Heinz is taking on some $7 billion of debt to finance the acquisition.