Tuesday, May 22, 2012
Individual Investors Yield Chase...Get Burned and Buy High and Sell Low..A Familiar Story..This Time It's High Yield Bonds
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.