We see the “Credit Crisis” as un-folding in three phases. The first phase is the collapse of real estate prices. The second is the collapse of the banking system that made all the real estate loans, and the third phase is the broader impact on the overall economy. Our view is that we have largely passed through the first two phases and are now evaluating the length and depth of phase three.

The biggest surprise to us was the realization of just how leveraged the financial system had become.The following chart shows diversion of Financial Services earnings from its long term relationship with Nominal GDP.

The fear that this financial leverage created was so great that Central banks and Governments were forced to effectively guarantee every bank and bank deposit before any semblance of interbank lending returned.

Given the carnage in the global banking system, it is reasonable to assume that the economic fallout will be long and deep. The consensus economic forecast now reflects this view. We would also note that 3-4 months ago the consensus economic forecast was for a mild, short recession. The consensus economic view has had an almost perfect record of being wrong. Our view is that the economy will likely contract sharply over the next two quarters but we do not subscribe to the multi-year “depression” scenario. The main rationale for this is that despite everything the markets have been through this year, we see no shortage of capital in the world. Recent data shows nearly $5 trillion in US money market funds alone. Cash levels are elevated in every mutual and pension fund and China and Japan have $2.5 Trillion in reserves. In the 1930’s the Fed raised rates and contracted the money supply. Now they are manning the printing presses and funding the entire banking system. This capital is waiting for the opportunity to buy cheap assets and, especially, to lend to the private sector at very attractive rates. Banks will not be lending aggressively for several years, but once they begin to make small steps toward granting credit in the next few months, credit spreads will begin to tighten rapidly. Unlike the 1930’s, there are alternative sources of capital actively seeking returns today and this capital will move aggres sively once bank credit starts to ?ow.

Let’s now look at credit market valuations and implied default rates. The high yield market closed on October 27, 2008 at a spread of 1,681 bps and a yield of 19.51%. These are extraordinary levels and well beyond anything ever experienced. In the last cycle, credit spreads peaked at 1,100 bp and default rates at nearly 12%. Today we have spreads approaching 1,700 bp and the default rate is 3.4%. Default rates will certainly rise from here – the question is how far?

The record for noninvestment grade corporate default rates, ~16%, occurred in 1933 amidst the Great Depression. Today’s spreads are discounting defaults nearly 30% in the next year, almost twice that of 1933. Furthermore, current spreads imply that virtually every current high yield company will default within five years. To belabor the point, at current spreads 20% of the current universe could default in each of the next three years and the market would still produce a positive return.

The primary reason spreads are at such elevated levels is the massive deleveraging of financial services balance sheets (see chart 1). Defaults actually have not risen to the long term average, let alone to levels implied by current spreads. High yield companies entered this downturn with, on average, the lowest leverage levels we have seen. Furthermore, a large number of high yield issuers refinanced in 2006 and 2007 at the tightest spreads in history. This will positively impact default rates as much of this debt does not come due until 2013 – 2015.

Our view is that current implied defaults are virtually impossible in all but the most severe of economic outcomes. With spreads peaking around 1,100 bp in each of the last three recessions, the high yield market returned 33% in 1982, 39% in 1991, and 28% in 2003.With spreads peaking closer to 2,000 bp this cycle the potential for significantly higher returns is excellent. The key will be to hedge against rising bond yields – and, of course, not be too early!

The Single Greatest Opportunity Ever in Credit Markets is Coming in the Next Few Months!

Reproduced with permission of Arrowhedge Barry Allan, Marret Asset Management Inc. who is the Sub-Advisor to Arrow High Yield Fund.