“We Wish We Bought Every Bond In The Index”: High Yield Knocks It Out Of The Park

I’ve been skeptical about the prospects for HY bonds (and especially HY energy) for some time now.

My skepticism has not dissipated.

In fact, the incredible returns one could have earned by being in HY in 2016 make me even more incredulous. Remember, when it comes to HY energy, we’re very often talking about cash flow negative US E&P names that rely on access to capital markets to plug their funding gaps. The following table is a bit dated, but it illustrates the point:

(Table: Citi)

See here’s the thing: a lot of these businesses should have gone under long ago, but between the Fed (keeping rates artificially suppressed drives a hunt for yield and thus ensures there’s plenty of investor appetite for HY credit no matter how risky) and more recently, rebounding oil prices, the market has been stripped of its ability to weed out insolvent businesses. Thus we get “zombie” companies.

Here, for those who haven’t seen it before, is the zombie creation cycle:

(Chart: Citi)

Bear in mind that the herding into risk assets means retail investors diving into vehicles like HYG. Trade in the underlying bonds is still relatively thin. That begs the obvious question: what happens when all those retail investors sell their HY ETFs at once and the managers are forced to liquidate the underlying bonds into an illiquid secondary market? I can tell you what happens: fire sale.

But that decidedly undesirable outcome has been forestalled yet again in 2016 thanks to an accommodative Fed and rising crude prices.

So basically, low rates have allowed uneconomic drillers to live to pump another day and that day comes at between $50 and $55/bbl. Of course the whole thing is self-defeating. Once these companies start pumping again they are effectively setting themselves up for failure by offsetting the very production cuts that drove prices back into the $50s in the first place.

In any event, 2016 was a banner year and as Bloomberg writes, HY investors’ only regret is that they didn’t buy more.

Via Bloomberg:

Last year, the biggest winners in the high-yield bond market were investors who eked out any positive gains. This year, even returns of 15 percent aren’t enough to make the top rank.

Blame commodities. Even investors who notched double-digit returns wound up trailing their benchmarks because they failed to take a chance on enough beaten-up energy and mining company bonds at the February bottom.

“In hindsight, we wish we bought almost every bond in the energy index in February,” said Michael Collins, a money manager at Prudential Fixed Income, which oversees $681 billion and has been underweight energy holdings this year. “But the fundamentals for a lot of high-yield energy companies are still not that great.”

No, no they are not. Here’s a comparison between returns on HY energy and default rates on the same debt:

(Charts: Goldman)

That makes sense, right? Of course it doesn’t, which is why issuance is flagging:

Even as high-yield bonds began to outperform, the new-issue market struggled to emerge from the doldrums. New bond sales plunged 14.3 percent from a year ago, Bloomberg data show, with high-yield energy companies selling about $28.7 billion of notes in all, the least since 2009.

Still, supply stepped up in December following OPEC’s production cut decision which means US producers will promptly raise more cash and drill themselves right back into a hole, as whatever OPEC removes from the market will be promptly replaced by opportunistic American drillers.