One theme I’ve been keen on highlighting this year is the growing divide between HY assets held in funds and the Street’s willingness to inventory HY bonds.
The problem is pretty straightforward. If outflows from HY bond funds exceed the amount of cash fund managers have on hand or otherwise exceed their capacity to tap bank lines of credit, they’ll need to sell the underlying bonds. Unfortunately, the underlying bonds barely trade. The market is illiquid. Given that, managers will need to offer the paper they hold at firesale prices in order to meet redemption requests.
The situation is so tenuous that even Virtu, the HFT firm that literally never loses money – won’t touch HY credit.
To be sure, I’m surprised that we’ve gone as long as we have without a complete HY meltdown (I’d imagine Riyadh is equally incredulous). Although the door seems to be closing slowly, lowly US energy producers have managed to stay afloat by tapping bond markets and secondaries. Some of these are basically zombie companies and just as soon as crude hits $50, they start pumping again, which ironically guarantees the supply glut will persist.
Now, beleaguered HY names face a fresh set of challenges emanating from election uncertainty in the US and the sectarian feud in the Mid-East that’s effectively keeping Iran and Iraq from agreeing to any kind of production freeze/cut. Here’s Goldman’s latest commentary on where we stand (emphasis mine):
HY has one of the worst weeks this year as political uncertainty mounts. Amidst nervousness around the US elections and the oil slump, the HY market widened by 55bp this week, one of the largest moves of the year. And when accounting for the tighter starting point for spreads, the five-day widening on a percentage basis ranks in the 98th percentile since the crisis and represents the worst move since December 11 when the Third Avenue news hit. From a performance standpoint, HY lost 1.43% over the past five sessions—the worst weekly return since February 12, in a year where three-quarters of the weeks have posted positive total returns (Exhibit 1). The risk off tone has also been visible in ETF flows with HYG for example experiencing its largest ever one- day outflow this week. Compared to HY, the move has been much more modest in IG, with spreads moving 4bp wider on the week, consistent with the decompression pattern in a risk off market.
Crude adds to the pressure. It was a bad week for energy with crude prices down 8%, sending HY E&P spreads 83bp wider in the past five sessions. Whereas HY was remarkably resilient this summer amidst episodes of oil price declines, HY has moved directionally with the fall in oil prices over the past two weeks, albeit at a lesser magnitude (with HY losing 3.9% vs. oil losing 12% since October 19) and in sympathy with the broader market weakness (Exhibit 2). This week’s selloff notwithstanding, we do not expect a return to the 2015 paradigm of an oil-dictated market. In our view, the ongoing selloff is a reversal of the post-OPEC meeting overreaction. Our commodities team continues to think the probability of OPEC reaching a deal on November 30 is low and even if the fear of low oil prices encourages OPEC to deliver an agreement, the odds of it successfully reducing inventories are also low (“Oil – Lower probability of a cut, even lower odds of success,” Commodities Research, October 31, 2016). Thus, with our commodity team’s expectation of range-bound prices—maintaining the year-end $43/bbl and 2017 $53/bbl WTI targets—we continue to think the credit markets have moved over the 2015 commodity hump.
Now consider this from Bloomberg:
The world’s richest oil billionaires had $4.6 billion wiped from their fortunes last week when oil capped the biggest weekly loss in almost 10 months as hopes faded that OPEC will be able to implement a promised deal to cut production and ease global oversupplies.
What can you say? It’s hard out here for a pimp…