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We have been stressing the tightness of spreads for many months now though we noted in our recent article titled “Current Valuations In the Bond Market- Part II” that spreads can remain tight for an extended period of time. Since the publication of that report, spreads have moved fairly sharply with the BofA HY OAS spread index falling for six straight days.
The sector has seen quite the run since the bottom of the market in 2009 returning 14% annually aided by low interest rates. In 2016, the space returned over 17% and is up another 7% in 2017 through the end of October.
While still at very low levels, the spread index has moved in a sharp fashion, especially the last few days. Could this be indicating an end to the bull market or some sort of correction, or is this simply profit-taking in an overvalued asset class?
The iShares iBoxx High Yield Corporate Bond ETF- (HYG) has seen a significant amount of volume in the last week. The ETF has been a popular place to park assets and generate a ~5% yield. We have always stated never buy a passive ETF that invests in fixed income. Bonds are a fairly illiquid asset class and to house them into a structure that is a actively-traded intraday vehicle is a dangerous strategy.
The main driver of the sell-off is likely a string of poor earnings reports by a few larger high yield issuers shining a spotlight on the sector. One of the latest is CenturyLink (NYSE:CTL), a heavily leveraged telecom that has several issues across many asset classes. The common shares are down from $23 a couple of weeks ago to just $15 today. The dividend yield of 13% is likely to be trimmed as the company needs to build cash as they integrate the Level 3 acquisition.
We also saw Community Health Systems (CYH) and Sprint (S) bonds sell off strongly on earnings news and the rumor that the merger talks with T-Mobile has ended. Other firms that issue high yield bonds like Tesla (TSLA), iHeartMedia, a host of other junk-rated issuers. The question is whether it will spread further and infect the broader market. It is already infecting the high yield market as spreads, which we noted above, have been widening out sharply in recent days.
Outside of a few poor earnings reports, a more likely driver of the wider spreads could be the Republican tax plan that proposed reducing corporate interest deductibility. Many junk bond issuers are highly leveraged and benefit substantially from this tax giveaway. Approximately 40% of the high yield market would be affected by having more interest expense than the cap.
At 5.70%, the high yield index’s effective yield is historically very low. But compared with other income-producing assets, especially on a global basis, the yield is attractive. Default rates are extremely low currently and have been falling amid strengthening economic growth and fundamentals.
Today’s spread of 367 bps is well below the 20-year average of 515 bps. We are now at the post-recession tights. The combination of the current spread and given that we are the tights is indicating to us that the market is ‘expensive’. Meanwhile, we have seen corporate debt explode in size and issuance given the low rate environment. Companies have issued prodigious amounts of debt in order to buy back shares or pay higher dividends.
One issue to watch is the maturity walls of corporate balance sheets. Eventually this debt will need to be rolled (or paid back). In today’s market, debt servicing costs are very low but if rates were to rise many banks may be hesitant to underwrite highly leveraged companies. This could create a default downward spiral.
Another worrying sign is the fact that an increasing percentage of new issuance is in the lowest quality bucket. CCC-rated debt issuance has been growing as a percentage of total issuance, a sign that lending is becoming ever looser and could result in a default surge. When we see higher CCC rated issuance, and a growing trend towards that level, it tends to forewarn widening spreads across the sector and well as lower returns.
Yield In A Yieldless World
While the 5.70% yield is near 15- year lows, it is relatively high compared with most of the rest of the developed world. The 10-year German bund yield is just 36 bps, compared with 2.33% in the U.S. Germany and the U.S have similar growth, employment, and inflation trends which should mean in a truly undistorted world they have similar interest rates. But the nearly 200 bps spread is a record and due to the ECB quantitative easing program as the Federal Reserve embarks on quantitative tightening.
European high yield is probably one of the areas of the market that is most overvalued- one could use the term “bubble” to describe the market. The drive for income producing assets in a yield-less world has driven investors to do crazy things. Investment grade bonds in Europe yield almost nothing with some bonds, thanks to European Central Bank buying, with a negative yield. Imagine loaning a business capital, and you paying THEM interest for the right.
The current market expectations for the default rate of the European high yield bond is now at -1.1%. Yes, you read that correctly. The long-term average for euro HY defaults is approximately 5.8%. We are clearly seeing the effects of distorted markets from quantitative easing and negative rate monetary policies.
There is an apparent moral hazard occurring in the European bond market as the ECB is essentially back-stopping any defaults on the continent.
Today, the yield on the European HY index is BELOW that of the U.S. 10-year treasury rate. Think about that for a moment. Junk rated debt in Europe, on average, has a lower yield than the safest bond in the world.
Is there anything that should cause us to get out now? While it’s expensive, there aren’t any problems that are embedded into the market currently that is likely to cause spreads to blow out like they did in 2008 and 2015. Longer-term, with such tight spreads, rising corporate debt, lower credit quality, and the prospect of tax reform possibly limiting interest deductibility, the risk return is skewed to the downside.
For now, we think the fundamentals for high yield remain solid enough that a widespread selloff where spreads widen out by 200–400 bps is highly unlikely without some outside catalyst (i.e. war with North Korea, government scandal, etc.). Given the hunt for yield, the demand for high yield is going to remain robust, especially for foreign buyers.
The current 7-day sell-off is likely in relation to the proposed tax reform compounded by some poor earnings reports by a few large high yield issuers. It should be noted that the last time high yield spreads widened significantly was in 2014-2015 when oil prices collapsed. Oil and oil services companies represent a significant portion of the high yield market. Today, West Texas Intermediate is near $55 which is supportive of our shale producers.
The larger question becomes, why has the correlation between the S&P 500 and HYG has been broken. Is the S&P 500 going to converge towards HYG or vice versa?
Our guess is that HYG is not doomed for a massive sell-off…. yet. Until the fundamentals in our economy deteriorate significantly, any moves in the spread index are really just noise based on regulatory or transitory issued. That is not to say that HY spreads shouldn’t be stationed at higher levels than currently situated. Caution is warranted for sure. Moving away from the CCC and up towards the higher end of high yield is a prudent measure.
Since March, we have been reducing our exposure to the junk in our Core Portfolio and moving up the credit spectrum, albeit slowly. Again, we don’t think investors need to rush for the exits and do not see any indicators that would cause us to get out of high yield entirely. However, given the current spread and yield environment, risk is definitely skewed to the downside.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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