“There’s A Good Chance The Selloff Is A Blip”: When Dumpster Diving Goes Wrong

In case there are still questions out there regarding how I feel about high yield (i.e. junk), allow me to state unequivocally that I believe the bottom is going to fall out of what, a bit of recent decompression notwithstanding, has turned into a 13-month rally.

Remember, HY “wobbled” earlier this month when crude plunged and it’s been…well… “wobbly” ever since. Have a look:

And see, here’s the thing. People are unwilling to give up on this until it’s too late. Recall what Citi said last month re: why investors are sticking around in an absurdly rich credit market:

If there is such a thing as a ‘Holy Grail’ in the credit market anno 2017 then surely the no-cost decompression trade is it — the trade that performs, if spreads widen, but doesn’t cost a bundle of carry if they don’t.

Spreads could evidently still compress further under some (optimistic) scenarios, but most portfolios are long to benchmark already and at current levels the potential downside greatly exceeds the potential upside no matter how you look at it. That leaves a glaring asymmetry.

Instead, we’d argue the principal concern people have with decompression trades here is that they tend to be negative carry. In a benign market, it is easy enough to de-risk by shortening maturities, selling higher beta bonds and/or moving to defensive sectors. But when spreads are low, volatility is low and dispersion is low, a few basis points of carry can matter a lot to a fund’s percentile performance against peers. And against the short-term metrics by which performance tends to be measured many will struggle to forego the incremental carry — until a negative trigger becomes immediately obvious.

Right. Of course at that point everyone is already on the way out the door. It’s the whole crowded theatre bit.

With all of the above in mind, consider the following out Thursday (i.e. before the GOP health care bill failed) from BofAML. Note the highlighted passages and think about them in the context of that last bolded passage from Citi.

Via BofAML

The last few weeks we have seen wobbles in high yield; a full 2 months earlier than we anticipated. What began as the expected effects of rate risk on higher quality high yield bled to unexpected lower crude prices and a repricing of the Energy index by 87bp (5.98% to 6.85%) and has further morphed into an early second guessing of the optimism surrounding policy. We think there is a good chance the selloff is a blip; and should the GOP deliver on the AHCA and move on to tax reform, the bid for yield could ramp up again now that valuations have backed up.

Now to be sure, BofAML also lists a lot of caveats and urges a bit of caution, but the message is pretty clear: don’t go dumpster diving (i.e. looking for bargains in junk bonds) unless you’re sure the coast is truly clear.