The zero interest rate policies (ZIRP) by the FED have hurt investors and savers, causing them to flee into higher yield bonds. Lured in by the higher yields investing in risky debt, investors have poured over $80 bn into US “high yield bonds” since the start of the emergency policies by the FED. Causing damage to the internals of the financial markets by the vast mispricing of illiquidity in these “high yield” markets.
For the past five years few asset classes have been chased as much as the high yield junk bonds by low rated companies. Prices have gone up and yields have gone down. In fact the name “high yield” is beginning to look outdated looking at the returns on higher risk debt. Data from Barclays shows the average yields on junk bonds (“high yield” bonds) reached a record low of a miserable 4.82% in June, miles away from the 22.9% seen in 2008 (figure 1). So has the bottom been reached? Over the past two months yields have risen from insanely low levels to, to be frank, still insane levels. The Bofa Merrill Lynch high yield index to 5.5% last Thursday. Last year in the heat of the tampering debates the index rose to 7%. But can it go harder than that?
Figure 1: BofA US High Yield Master II Effective yield.
The formation of bubbles
Commonly asset bubbles are formed when prices of asset rise above levels the underlying fundamentals cannot longer support. Looking at the past this mostly happened during periods of extreme low interest rates, increased money supply or highly accommodative monetary policies. Sound familiar? Investors seem to realize that the high yield market is in dangerous territory. There seems the be a real disconnect between the real economic fundamentals and the pricing in these market. This is enforced by the words of no one less the Chairman of the FED herself who said that the prices is the high yield markets “appeared stretched”
There are already signs that the bond market is getting nervous. For the last couple of weeks investors have pulled billions of funds from the markets. (figure 2). According to Barclays, investors pulled $3.8 billion from high-yield mutual funds and $2.2 billion from high-yield exchange-traded funds. The highest outflow since june last year, for the same reasons mentioned earlier, the taper tantrum by the FED.
Figure 2: High Yield fund flows US in $ bn.
Problems of illiquidity
The problem is that when Bond funds are faced with a flood of redemptions that cannot be leveled with their cash positions, they will first sell their positions that are most liquid and have lost the least value. From a distance little damage is visible to the bond-fund holders. Only when redemptions continue the funds have to keep selling increasingly attractive debt papers on increasingly illiquid markets. Yields will rise prices will drop. When the bond fund holder get a hold of this they start dumping their shares and forced selling commences. A case where the sellers will start lining up and the buyers will be gone.
When in such an illiquid market selling really takes of, yields of these junk papers might soon be back towards into the 20%/30% region. If this will not happen naturally it will happen when the FED’s QE stops and the ZIRP will wander off. Many overleveraged companies will never be able to refinance all their debt causing them to default.
“We should be mindful of significant primary market volumes compared to lacklustre secondary markets. Recently, investors have not required large amounts of secondary market liquidity but at some point they will.” -Jim Esposito, co-head of the global financing group at Goldman Sachs.
The magnitude of the illiquidity of the markets can be seen looking at the Dealer inventories of corporate bonds (figure 3,4,5). They have gone down an almost 75% percent from pre-crash levels, meaning that the ratio of dealer inventories to their bond fund assets in virtually non existent. Where in 2008 this ratio was 15% at present day it is a mere 1.5%. With That trading volumes have been halved since the beginning of the crisis.
Figure 3,4,5: Lower volumes and smaller inventories.
Leading to the simple conclusion, when the financial market will turn to a large sell-off the corporate bond market will go down violently. As one analyst put in:
“Everyone is hoping to be first through the exit, by definition, that’s not possible.”Matt King, global head of credit strategy at Citigroup in London.
Another point of interest is that the spreads between higher-grade and lower-grade bonds are widening. When we look at the lowest of the low, concerning corporate bonds, BBB-rated bonds and BB-rated bonds (the high end junk) we see the spread widening out (figure 6).
Figure 6: BBB USD 10yr - BB USD 10yr (Otterwood Capital)
Looking at the spread levels we see that they are squeezed towards absurd levels. Before last weeks sell off they were less than 300 basis points (figure 7). Where a spread of 600 would be more healthy. During the last junk bond sell of the yield spread over the treasury benchmark was a whopping 2000 basis points. Problems are that, as explained earlier, the market is in awful lot larger, trading liquidity an awful lot thinner and FED already is using its ZIRP trump card. So when the junk markets comes crashing down, this time it will be even worse.
Figure 7: BofA Merril Lynch US High Yield Option Spread & US Corporate AAA Yield
Although High Yield bonds offer little to no risk-adjusted value on the long-term, even after the recent sell-of. I would adivse you keep a safe distant from this market. But with ZIRP estimated to continue untill as far as Q3 2015 we can't expect High Yield bonds to really crash just yet (figure 9). Furthermore we are still in the middle of the current Credit Cycle (figure 8), thus it seems that we can still expect tight spreads for the coming 12 months or so.
Figure 8: Analysis of Credit Cycle duration (Source: Morgan Stanley)
Figure 9: FOMC and Market rate expectations till 2017 (Source: Credit Suisse).
What should investors be the most worried about?
Even as the High Yield bond space is overstreched, some sectors are more overvalued than others. An extensive valuation analysis conducted by Guggenheim Partners might give investors hints as to which sectors one should most definetly avoid and where there might still be some value (figure 10). Within the High Yield credit space the riskiest bonds seem to be the most overvalued compared to historical standards. Corporate CCC-rated Bonds are dangerously stretched. While CCC-rated Bank Loans and BB-rated Corporate bonds aren't far behind. With regards to relative valuations B-rated Corporate Bonds and B-rated Bank Loans might still offer some a "shred of value" for yield starved investor. But all in all I would stay away from High Yield bonds in general.
Investors should be very aware of high yield debt going into 2015. As the fundamentals will really start to turn in this year.
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Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.