Concerns about economic weakness and turmoil in the credit markets are likely to weigh on high yield and convertible bond closed-end funds (CEFs) over the next several months. Since late-2007 dislocations in the credit markets have contributed to tighter financial conditions which may push the US economy into recession. Similarly, credit strategists believe we have begun a long term cycle of more expensive lending and significantly tighter credit criteria. This could take a few years to run its course (the last occurring 1998-2002). Credit strategists expect the default rate to begin rising sharply towards 4½% in 2008 and 5% in 2009 from ½% in 2007, with a recessionary scenario pushing the default rate even higher. Along with the overhang of large amounts of planned new corporate debt issues, the confluence of these negative economic trends provides major challenges to the corporate credit sectors.

Nationwide, about 370,000 new homes are for sale because people who initially contracted to buy them backed out; as a consequence, record number of homes sit empty. On top of these disheartening numbers, an additional 216,000 homes are under construction. Partially completed developments reduce revenue for cities and towns and hurt businesses. Rising foreclosures and falling property values may cut tax revenue by billion of dollars for states like New York, California and Florida.

Simultaneous with a decline in local governments’ revenue, the rating agencies, Moody’s, S&P and Fitch, have downgraded or put on watch for downgrade several of the companies that insure municipal debt. AMBAC, Assured Guaranty, CIFG, FGIC, MBIA and XLCA have all been affected. The combined effects of doubt in the insurers’ ability and a declining economy have severely weakened the market for municipal debt. Thus, tax free municipal bonds are trading at historically wide spread (high yields) relative to US Treasuries. This has created an intriguing buying opportunity for investors in municipal bonds and municipal CEFs which are trading at wide relative discounts to net asset value.

Trying to spur lending and avert a recession, the Fed has chopped 2.25 percentage points off its benchmark rate since September. Wariness among lenders and fears of inflation are keeping mortgage and auto loan rates close to or above levels before the central bank began easing, while credit-card issuers are tightening their standards. The slippage between the Fed’s rate cuts and consumers’ ability to borrow or reduce loan costs is weakening the central bank’s ability to stimulate the biggest part of the economy, consumer spending. It accounts for more than two-thirds of goods and services output and stalled for the second consecutive month in January after adjusting for inflation, the Commerce Department said today. Banks have tightened standards and terms for a broad range of loan types over the past three months.

Michael Ashley Schulman, CFA
Hollencrest Capital Management