Bonds: High Yield
By now one would have expected junk bonds to have experienced a large selloff. The sector already had a low spread to Treasuries, has mountains of fringe credits, and has been facing a period of rising rates. Yet, high yield has been performing very well, with the weakest credits, paradoxically, performing best. There has been no sustained flight out of the sector, and spreads are higher than at the start of the month, but still not even where they were for much of the year.
FINSUM: The big risk here is that investors aren’t being paid enough for the risks they are taking. The whole junk sector, not to mention the loads of BBB credits that are technically investment grade, are very susceptible to recession and higher rates. At some point there are going to be some major losses.
Junk bonds have had a rough monthly, and it is not hard to see why. The rise in yields and the anxiety about stocks have combined to push yields on junk steeply higher, from 6.18% on October 1st to 6.61% now. In aggregate, the bonds are down 1%+ this month. However, the truth is that the losses could have been much worse, and within that idea, is an important story. That story is that ETFs, which have offered much greater ease of access to investors, actually seemed to have supported prices in the recent turmoil. The head of bond trading at Oppenheimer put it best, saying “The ETF market, which was supposed to subtract liquidity from credit markets, is actually adding liquidity by aggregating the risk and bringing in people who want to take macro risk as opposed to micro bond level risk … The ETF market ends up providing the live bid-ask spread that even the credit markets themselves cannot generate”.
FINSUM: This is a fascinating argument as it runs counter to the long-running narrative about how fixed income ETFs could cause a big blow up because of a “liquidity mismatch” between ETFs and the underlying asset.
Some are very worried a junk bond bear market might be on its way. Not only are rates and yields rising fast, but there has been a huge run up in high yield prices over the years, with a simultaneous surge in bottom rung BBB bonds. However, despite this scary back drop, the market has been doing well and looks set to continue to do so. “The key dynamic in the high-yield market is recession … There’s a possibility of some economic shock that isn’t apparent right now, but you don’t have the classic signs pointing to recession”, says one CIO. High yield’s spread to Treasuries recently touched its lowest point since the Crisis, and in a twist, the lowest rated bonds (CCC) are performing the best this year.
FINSUM: This is quite confounding in many ways, especially considering there have been significant outflows from junk bond funds and investors can get good returns from investment grade.
The junk bond sector feels like it is on the precipice right now. After years of great performance, valuations and yields are at lofty levels. At the same time, there has never been more BBB bonds, or bonds just one notch up from junk. All of that means the market looks fragile. However, one of the lesser discussed risks in the high yield market regards a sea-change in accounting practices. Just as with startups, the high yield sector has seen major growth in suspicious accounting practices, such as inflating EBITDA to make debt multiples look lower. Often times this is done on a highly speculative basis that misleads investors.
FINSUM: This is just one of the many growing risks in the high yield market. It seems like the SEC needs to crack down on this sort of creative accounting.