Fair-Weather Friends In Junk

We’ve got a veritable laundry list of concerns about high yield corporate credit ETFs.

If you’re interested in such things, you should check out “What Happens When You Have To Play That Piano Drunk?” Some folks liked that one.

Probably the most glaring issue with junk bond ETFs is that they offer investors daily liquidity (you can trade the ETF just like a stock), even though the underlying bonds are anything but liquid. We’ve been over that a thousand goddamn times.

As long as the flows are diversifiable, that will work. That is, as long as one manager is seeing inflows when another is seeing outflows, then everyone can just swap portfolio products and investors will be none the wiser.

But if all the flows should become unidirectional (i.e. everyone is selling), well then now there’s a problem. And do you know why? Because the Street won’t lend you its balance sheet anymore. Compare and contrast (top is pre-crisis, bottom is post-crisis):

BeforeAfter

(Barclays)

So with that as the backdrop, you might also want to consider that dealers are fair-weather friends these days. Have a look at this:

InevntoriesDealerJunk

Notice anything about when dealers tend to get gun-shy? Inventories collapsed in August 2015, February 2016, and just a few weeks ago when the March rout in oil prices caused the correlation between HY and crude to spike.

Also note that dealer inventories hit a 2-year high in early March right when HY spreads compressed to near post-crisis tights.

In other words, they’re around when you don’t need them and not so much when you do.

Via Deutsche Bank

An interesting development has transpired in dealer positioning, where HY inventories have recently spiked to just over $7bn, their highest level in more than two years (Figure 1). This peak in dealer balance sheets coincided perfectly with HY spreads reaching their post-2014 lows in early March. Subsequently, inventories were abruptly reversed, and the current dealer positioning shows only $3bn in aggregate holdings. The drop from $7bn peak to the current level was the sharpest reversal in this dataset going back four years, or as far as the Fed’s data goes.

On a more general note, dealer positioning in HY appears quite pro-cyclical over time, as it shows them going into the episode of spread widening in late 2014 with high inventories, averaging $6-8bn, only to be cut gradually as credit spreads widened. The low print of zero inventories was reached in early 2016, coinciding with peak spreads. While this is not particularly surprising, it is interesting to observe such a behavior in the data.

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