Ok, dammit.
It’s time for another junk bond post.
On Tuesday evening, we showed you what a tailwind in junk looks like, as a dearth of supply ended up driving yields sharply lower in July. At one point, yields fell for 10 consecutive sessions:
Well, junk yields are now at 5.36%, which puts them within shouting distance of all-time lows.
Another fun factoid: BB yields declined in 11 of the previous 12 sessions.
The particularly interesting thing about this is that it comes as IG is outperforming – something else we’ve talked about recently. Here’s some further color on that from BofAML:
Reflecting on recent moves in corporate credit the most striking aspect is the outperformance of high grade vs. high yield. Since 1997 there have only been five instances of three-month periods where the average monthly excess return for high grade was at least 50bps and for high yield only up to 25% better (beta<1.25) — including the most recent period May-July 2017. Before that were the overlapping Aug-Oct 2012 and Jul-Sep 2012 periods following ECB President Draghi’s famous pledge to do what it takes to save the Euro. Prior to that the period Nov 2008-Jan 2009 as policy intervention, including QE, calmed markets at the height of the financial crisis. The earliest such period was Mar-May 2001 as the Fed lowered rates aggressively into the recession. What is most remarkable is that HG was able to generate such performance from initial spreads of just 123bps, as opposed to at least 180-577bps in previous episodes. While there are several reasons this time the main driver of high grade outperformance is the backdrop of weakness in US economic data — but not too weak — and the lack of inflation globally that ensures foreign central banks remain very dovish and motivate large inflows into US high grade assets.
Well anyway, if you’re in junk, it’s worth noting that in all likelihood this is going to end horribly – especially considering the extent to which market pricing of this debt has become completely detached from the issuers’ ability to service it.
Consider this out Tuesday from SocGen’s Andrew Lapthorne:
Global equities rose again last month, leaving MSCI World up 2.3% in July, its eighth monthly price rise in a row, its best run since the 2003 recovery and the fourth-longest monthly winning run on record. Whilst impressive, these long positive runs are not actually harbingers of impending doom; of the five winning runs over seven months or more for MSCI World since 1969, returns were still positive a year later. So there is little to fear from a run of gains per se.
However, these ‘winning’ streaks do help suppress risks, and volatility, implied or realised, remains very low. As the chart below shows, realised 60-day volatility on both the index and at the individual stock level is bouncing around its historical lows. Realised volatility is 40% lower than its historical average, while volatility on average stocks is significantly lower than it has been historically. Asset price confidence is therefore at record highs.
Why does all this matter?
Well again, low price volatility in itself does not predict much, but it can create mispricing. In particular, high confidence as to what an asset is worth can lead to underestimating the potential downside risks, which happens almost mechanically in high yield debt markets where asset volatility informs part of the pricing model. The implication is that high yield credit could be 30%+ mispriced as and when volatility moves back to average.
If Andrew is right and we do end up getting a correction of that magnitude in HY, the rickety, untested structure of HY ETFs is going to get a trial by fire. I for one, do not believe those vehicles will pass with anything that even approximates flying colors.
Also note that HYG is being used as a liquidity sleeve by active managers. That is, they are substituting HYG for cash buffers so they can remain fully invested. If, as Howard Marks has warned, that ETF isn’t any more liquid than the underlying bonds it proxies for, those active managers will find that they actually have no cash on hand in a pinch because what they assumed was a cash equivalent (HYG) was in fact nothing more than a derivative of the bonds it represents – the same bonds they’re holding.
Looking into my (blue) “crystal” (get it?) ball, I see this:
— Heisenberg Report (@heisenbergrpt) July 28, 2017
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