Story Highlights:
- The current inflows into high-yield debt are not sustainable and are overdone.
- High-yield securities are directly correlated with overall economic recovery.
- Selling pressure has been regenerated as of late.
The current pace and concentration of inflows into high-yield debt, resulting in a steep rally of high-yield bond prices, are simply not sustainable and are overdone. Investors are eating up riskier assets without much restraint as investment grade and Treasury yields appear unattractive – around 3.5%. High-yield (“junk”) bond funds are up over 51% this year, as their prices have rallied from record levels earlier this year. Demand for junk securities has led to their eighth straight monthly gain, the longest consecutive streak since June 2007.
In and around the lows, these speculative securities presented investors with yields in the 18-25% handle. Due to the incredible resiliency of these securities, investors are now presented with yields in the 10-12% range, which hovers quite near the “when times were good” yield of 9%. With high-yield default rates, Bloomberg reports 12.4%, still well above the average long-term rate of 4.75%, the market has truly exaggerated the improvement to creditworthiness of these securities.
One investment vehicle which is particularly useful to monitor the general market sentiment towards the riskiness of high-yield corporate credit is a CDS index (CDX), such as the Markit HY Credit Index. Credit Default Swap contracts are commonly referred to as “bond insurance.” Simply put, the buyer of a CDS contract pays a premium and receives face value if an issuer defaults. The 5YR Markit HY CDX Index is composed of 100 non-investment grade entities determined by a consortium of 16 member banks. Traders find a CDX index useful in speculating in overall credit worthiness, or to hedge against losses in a bond portfolio. This index, which includes names such as CIT, AMR, and ResCap, has remarkably seen retracement all the way back to mid-2008 levels. Sellers of protection are driving the index down as they estimate less than expected default rates for high yield issuers.
High-yield market participants seem to be ignoring current speculative-grade default rates and are trading as if there will be a steep decline in defaults. Essentially, this speculative grade rally mimics a V-shaped economic recovery. Difficult labor-market conditions and ending Federal Reserve programs will cause headwind in 2010. A moderate recovery will lead high-yield investors to cash out and will likely spur a continuation of high-yield issuers defaulting. Despite the growing concerns and beliefs that we will be having a sluggish recovery, it is quite shocking that investors are willing to put their neck out on the line and sell protection for high-yield issuers.
The cost to protect against defaults on U.S. corporate bonds fell each day last week. Last Friday the jump in unemployment strengthened speculation that job market strains will support the Federal Reserve’s pledge to keep interest rates low. Barclays strategist Ashish Shah stated, “With the Fed likely on hold for longer, and Treasury yields low, the search for yield that has benefited credit is likely to continue.” While I agree on the statement that investors are still out to find attractive returns, my concern is that for the majority of the year, high-yield investors invited only the higher-rated companies into the junk bond rally. Recently, however, investors seeking juicy yields, comparable to what they may have missed, have been buying speculative low-rated securities which mimics exactly what occurred during the credit boom.
After their best year in history, there are signs that the market is re-evaluating high-yield securities and recent concerns have generated selling pressure. Last week we saw the first decline in high-yield bond sales, $3.07 billion, which is a 49% decline from the previous week. Bill Gross, owner of PIMCO, the world’s largest bond fund, also publicly stated last week that he believes junk bonds have peaked and will see retracement, saying, “The six-month rally in risk assets – while still continuously supported by the Fed and Treasury policymakers – is likely at its pinnacle.”
I believe the true pressures which will drive high-yield securities down is that they are so heavily correlated to how the market views the speed of improvement with regards to the overall economy. In contrast to a quick resurgence, stretching out the recovery will specifically spur aggravation in the high-yield space due to these issuers having high “default-rate sensitivity” to issues such as unemployment, retail sales, and continued defaults of other issuers.
