High Yield Bonds have sold off significantly in the past few
days as can be seen of this chart of HYG and JNK.
The sharp spike in volume seen in the chart above doubtless marks heavy
selling at the recent low. Additionally the ETFs have traded at their highest discounts to intrinsic value of the
year . Between May 16 -18 the discount to intrinsic value for ETF JNK reached -1.27% on the 17th. Most of the
year the ETF has traded at a premium to intrinsic value and as of May 22 has
returned to a premium. This discount is
a sign that funds and bond dealers hedged their positions in high yield bonds
by selling the liquid ETF while looking
for a market to sell some of their cash bond
holdings . It is certainly no
coincidence that the large discounts matched the dates for major fund
redemptions.
Not surprisingly, retail investors have been running for the
exits in response to the selloff. According to the WSJ:
Investors pulled $688 million out of high yield
mutual and exchange traded funds in the week ended May 16, marking just the
second week of net outflows this year, while equity funds have suffered net
outflows since mid-April, according to Lipper.
But the WSJ ‘s
explanation in that same article doesn’t make much sense to me:
The shift shows contagion of worries about
macroeconomic risk that weighed down stocks for much of May but had previously
not affected high-yield bond markets.
Not much of an explanation if one looks at the dates of the
selloff. High yield bonds have held steady during most of the worst recnt news about Europe and throughout the
stock selloff. Why the sudden move down ? I haven’t seen a good dissection of
the trades in the JP Morgan debacle. An SA contributor had made a nice attempt
here. However….
The timeline of the JP Morgan news and the high yield movement
seems to argue that there is a connection. JP Morgan Chase went public with
news of the losses on May 10. JNK prices
stayed steady until May 11 and then began 10 successive days of losses,
dropping 2.7% in 10 days. The S+P 500 (etf SPY) fell a similar amount over that
period. But the stock selloff was a continuation of pattern that began at the
beginning of May . So was the high yield bond market a case of those bond
investors suddenly waking up to the dangers
in the financial markets….I think not
So my working hypothesis is a bit different. The initial
high yield bond selloff was related to the unwind of the JP Morgan trade
disaster. Retail investors got caught in the crossfire. When they panicked and
sold they caused a bit of a wave of selling…net result a 2.5%+ decline over the
course of 10 trading days.
Regardless of what caused the selloff the reaction of, those
individual investors who had been chasing yield by buying high yield in large
quantities over recent months was not surprising: They quickly ran for the
exits after piling into high yield bonds for the past several quarters .Datafrom Lipper give the story of individual investors during the selloff (my bolds and italics and !):
$816
million in outflows from high yield mutual funds in the week ending May 16….after
an inflow of $754 million the week before ! $778 million came out of JNK a high yield
ETF. Since the selloff continued past the week of May 16, I have no doubt
this weeks data will give a similar picture.
What does this mean for the savvy investor: probably an
opportunity for investors to add a bit to their high yield positions if the
selloff resumes.. The downturn in prices
of course means a higher yield and with the rally in treasuries, JNK with a
yield of 7.52% has a 5.7% yield advantage over IPE the equivalent maturity
Treasury Bond ETF. That’s bit over the
long term average of 5.5% . The market has steadied as of today’s trading (May
22) and the ETF has moved to a premium But any further selloffs would be that
buying opportunity. Further price decline (and higher yields)and a move of ETFs
to a discount would likely be attractive.
Once again individual investors seem to have chased
performance and yield and then missed out on the long term potential of asset
allocation. High yield bonds certainly
carry higher volatility and higher correlation to stocks than Treasuries and investment grade corporate bonds. And in
most recent financial crises high yield has suffered big losses. But by
watching the interest rate spreads between high yield bonds and Treasuries, and making
such assets a relatively small part of an asset allocation high yield
bonds can be a productinve addition to a portfolio. I explained how to avoid
yield chasing and criteria for buying high yield bonds here But chasing yields with too high an
allocation and poor appreciation of the risks is a recipe for losses.
