We’ve variously marveled at the sheer scope and rapidity of the recent rally in risky credit, both junk and leveraged loans.
In fact, the abrupt about-face that’s played out over the course of the last week feels like it’s being driven by something other than the readily identifiable catalysts (e.g., the Fed’s dovish pivot, crude’s surge, dearth of supply). Whatever the case, it’s astonishing – spreads have come in by ~90bps since last Friday.
Needless to say, this has been accompanied by an equally startling rally in everyone’s favorite liquidity-mismatched junk ETFs. HYG was riding a six-session win streak headed into Friday, marking a stark contrast to Q4 when the product tied a record for consecutive daily losses (nine) in November and then plunged for seven straight days last month. It’s now well on its way to erasing the November/December slump, inflows are back and the discount to NAV (read: a test of its structural integrity) has turned into a premium, suggesting too much money chasing too few assets – or something.
“While the market can continue to trend tighter in coming weeks, we think a pullback is possible and even likely here, just given the intensity of the move so far”, BofAML writes, in a Friday note, adding that “in the 12 year history of HYG, it has only managed to post stronger 10-day gain in two instances: in 2011 when the market rallied from 900bps levels, and in 2009, when the market was coming out of the global financial crisis with 1,800bps spreads.”
Clearly, this is not the GFC. “Spreads are not in 900s this time around and this is not 2009”, BofAML flatly reminds you.
This has also meant that a chart of the HY/IG ratio betrays manic decompression (in December) and then a quick snapback (in January). Here’s what that looks like:
In a Thursday note, Goldman goes over the contributing factors. As far as the HY side of the equation goes, the bank mentions everything you’d expect from “a persistent lack of supply” – i.e., a complete dearth of new junk deals in December – “positive momentum in US equities” – i.e., the rampant risk-on sentiment catalyzed by Jerome Powell and, to a lesser extent, December payrolls basically cancelling out the dastardly December ISM manufacturing data – and “a 23% rebound in WTI which is relevant considering the HY market’s 14% weighting towards the Energy sector.”
That Energy weighting is indeed “relevant” and BofAML underscored just how “relevant” in the same note cited above.
“If you think the recent risk reversal was wild in major asset classes, try telling this to an energy-focused investor”, the bank quips, on the way to noting that “the blow up came early [as] oil slumped in early October, went deeper [with] energy HY underperforming by 500bps in Q4, and reversed itself even faster now outperforming by 140bps.” The following visual isn’t a perfect illustration, but it’ll work.
Ok, getting back to IG, Goldman explains range-bound spreads in high grade as follows:
After a lackluster December for IG debt issuance (just $12 billion priced – the slowest December since 1995), IG new issue activity has resurfaced in recent days, with nearly $40 billion issued month-to-date (excluding EM issuance). A handful of late-2018/early-2019 M&A announcements – mainly from IG-rated acquirers – also caught many market participants by surprise, given the popular market narrative that elevated volatility was likely to suppress deal-making in 2019 (as well as M&A-related debt issuance). A continued focus on downgrade risk from A to BBB – and in more limited instances, to HY – has also kept IG spreads from rallying as much as the HY peer group.
In short, that’s why IG hasn’t rallied with HY and so, the decompression/’re’compression shown above is basically just down to wild swings in junk. This is self-evident to anyone who follows this on daily basis, but it’s worth laying out nevertheless.
So, what happens now? Well, common sense dictates that the HY rally has overshot and that (cat calls about IG being the next landmine notwithstanding) IG is in a better position to weather the storm in the event the cycle does turn and margin pressures materialize.
“Fundamentally, we continue to view the IG universe as better equipped to handle the host of late-cycle margin pressures currently weighing on non-financial corporates”, Goldman writes.
“All changes to positioning should be viewed as a tactical reaction to very strong moves in the markets since early January, not as changes to our fundamental view this could be a turn in the credit cycle”, BofAML’s HY credit team cautions, before noting that while “the return of risk appetite helps decrease the probability of irreversible tightening in financial conditions, it would be too premature to argue conclusively that this is an all-clear signal.”
Correct. Or, as Jeff Gundlach would put it:
This is a gift. Get out of [high yield].
So, assuming you’re not enamored with gold, I guess the only “safe asset” to invest in right now might be a 24-pound, 180-serving “Storage Bucket” of mac and cheese available from Costco. This is in the news on Friday and as you can see from the visual below, it’s got a 20-year shelf-life, only costs $90 (shipping and handling is included) and could be delivered to your doorstep within 5-7 business days were it not sold out.
It seems likely that the “out of stock” label there reflects an acute demand for tail hedges among investors, consistent with still-elevated money market assets which have kept climbing in the new year.
According to People, you can also store 100 baseballs, half a bale of hay or, if you like, your “3-year-old child” in that mac-and-cheese bucket assuming you ever get to the bottom of it with your spoon (or shovel, whichever you prefer when digging into 24 pounds of pasta).
Can you say that for you physical gold or your money market fund? I didn’t think so.