Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives

CHAPTER 9

Recessions and Returns

A question commonly asked by investors in the leveraged finance market is the extent of their exposure during an economic downturn. The answer is usually dependent on whether an investor expects that the economic downtown will be fairly short and shallow or whether it will be deep and protracted. In most cases, investors should be poised to add exposure if the former is true but trim risk positions if the latter appears more likely.

In this chapter, we assess return prospects during economic downtowns. In order to do so, we examine the relationship between economic growth and valuations during the previous five recessionary periods in the United States prior to the 2007 setback: (1) November 1973 to March 1975; (2) January 1980 to July 1980; (3) July 1981 to November 1982; (4) July 1990 to March 1991; and, (5) March 2001 to November 2001. Specifically, we considered each setback in distinct parts:

1. A pre-setback period, which is defined as the six months preceding the actual recession.

2. The actual recessionary period.

3. A post-setback period, which is defined as the six months following the official conclusion of each recession.

In addition to looking at the performance at the broad market level, we study the performance at the sector level and across ratings categories.

BROAD MARKET PERFORMANCE

In Table 9.1, we present the cumulative total return and excess return of five-year Treasuries, high-grade, high-yield, and equity markets. The following ...