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Monday, August 18, 2014

About that Selloff in High Yield Bonds

What is Going On in High Yield Bonds:

High yield bonds and the Etfs in the sector have definitely had a rough period since the beginning of July.
For example HYG this ishares intermediate term high yield bond ETF had a loss of 2.5% in July.

The reasons cited in many recent articles don’t quite make sense to me and I think the explanation can be found in some other factors specific to this market which I explain below

Among the reasons cited in recent analyses :
·         The crisis in the Ukraine: hard to see why this would have an impact on US high yield bonds. Does poitical uncertainty in Europe really increase the risk of high yield US corporate bond ?.If the major risk in high yield corporate bonds in the long term comes from risk of higher defaults it’s hard to see the relationship here

·         Higher US interest rates or the prospect of higher rates. It is hard to explain much of a reason why interest rates specifically on high yield bonds would react differently to the level of interest rates across the entire market relative to other bonds (as opposed to credit spreads…see below). The year US Treasury Bonds recently fell to lows of the year close to 2.4%, so the bond market overall is not indicating likely increase in interest rates.

A recent article from an analyst from RBS published in the Financial Times ties the risk of higher interest rates to a particular risk in high yield bonds

·         Increased default risk. Higher US interest rates would come about only if the prospects for the overall economy improves. The risk of defaults on high yield bonds occurs during recessions, not recoveries. Higher interest rates would raise the debt service expense for new issuers of high yield bonds….but during the extended period of low rates for high yield bonds, many companies took advantage of the low rates to refinance at lower rates or issue new long term bonds in the low interest rate environment.
Higher default risk would result in a widening of credit spreads of high yield vs Treasuries and investment grade bonds. It is true such spreads which extremely low levels as illustrated in the graph below long term averages. However note on the following graph that the shaded periods corresponding to recessions are periods of extremely high spreads for high yield bonds vs Treasuries. This is logical recessions increased risk of defaults.

Taking out the extreme periods of high spreads during recessions, one could argue that current levels of high yield bonds above treasury bonds are low…they are not at extreme levels if we are heading towards an economic recovery Using the two ETFs based upon the above indices we see the following yields for ETFs with a duration of about 4.5 years, They show a differential of 4%
US Treasuries GOVT yield = 1.28%
JNK High Yield Bonds 5.29%

Below is a chart of the differential (spread) between high yield bonds and US Treasury bonds:

What Has Really Driven the Sharp Decline in High Yield Bonds in July?

So if the above “fundamental factors” present a poor rationale for the recent selloff in high yield bonds what explains the move.

As is often the case the answer comes as much if not more from internals within the markets rather than explanations based on “market fundamentals”.

The most important factor is the flow of performance and yield chasing individual investors who poured money into high yield bond funds and ETFs without sufficient knowledge of the potential risks. Observers of the somewhat cynical investment observers (guilty as charged) call this “hot money” and tourist investors (new and inexperienced investors in an asset class) When the losses came these investors liquidated their positions in massive numbers

Retail-cash outflows from high-yield funds ballooned to a shocking, record $7.07 billion in the week ended Aug. 6, with ETFs representing just 18% of the sum, or roughly $1.28 billion, according to Lipper. The huge redemption blows out past the prior record outflow of $4.63 billion in June 2013.
With four straight weeks of outflows from the asset class totaling $12.6 billion, the four-week trailing average expands to negative $3.15 billion per week, from $1.4 billion last week. This reading is also a record, eclipsing a prior record at $2.8 billion, also in June 2013.
The full-year reading is now deeply in the red, at $5.9 billion, with 43% of the withdrawal tied to ETFs. One year ago at this time outflows were $3.9 billion, with 15% linked to the ETF segment

This week’s outflows also mark four straight weeks of redemptions from junk bonds, totaling $12.6bn.

Individual investors in their “search for yield” have been moving from their usual investments in CDs and treasury bonds into many asset classes with which they have little experience. High yield bonds are just one of these.Others include master limited partnerships, floating rate loans, emerging market bonds and reits. Investors have also moved money into “dividend growth” stocks viewing them as a substitute for all or part of their bond allocation. Many of the factors that affected the high yield market as of late have much in common with the aforementioned asset classes. The short temper tantrum” in the bond market of May- June of last year had negative impact on all of these assets.

Simply put, money from individual investors poured into High yield bond funds in unprecedented amounts. And the investments in the asset class reached record amounts. A relatively small sector of the bond market saw huge inflows…and potential liquidity problems.

These “tourist investors” underestimated the risks associated with these bonds. And the financial “services” industry always in search of new product churned out new ETFs and mutual funds in the asset class. And I am sure more than a few in the financial industry weren’t clear in explaining to clients the risk and return of such instruments either through commission (pun intended) or omission.

The “democratization of investing” which through ETFs is in my view certainly a positive development.

Nevertheless as John Bogle of Vanguard has pointed out the ease of investing in ETFs and the massive numbers available also can tempt investors to turn into traders or to make allocations in areas outside of major asset class that they don’t fully understand.

The easy access to the high yield bond market through ETFs and mutual funds is a good thing. It allows investors to broaden their exposure across the spectrum of credit risk in bonds. However the rapid growth has meant that unprecedented amounts have gone into a market that has never seen such large flows. The combination of many unsophisticated investors, a short time horizon, and a relatively small market means that large flows can disrupt the market.

The high yield bond market is not as liquid as markets such as US treasury bonds. When the market starts to reverse the price moves can be large and those losses spur further sales. As a consequence the market can experience large short term price distortions. This could be clearly seen in the large intraday price swings particularly in days of high volume. It was not uncommon to see ETFs trade at significant discounts to their intrinsic value (the market value of the bonds held by the ETF). 

Furthermore mutual fund managers who saw redemptions as well are forced to sell bonds into a declining market adding further to the negative feedback loop.

And there was a derivative element as well.  With the interest in higher yielding securities the “creative minds” of the financial industry saw an opportunity and created a range of derivatives related to high yield bonds. Since derivatives generally create leveraged exposure to an asset class. When markets reverse liquidations related to derivatives add more downside pressure.There has also been high volume in put options on high yield bond etfs.

High yield bonds are an extreme case of changes that have occurred in the bond markets in recent years. In response to regulatory changes and risk controls banks and investment banks have cut back in their activity in the bond markets. They have cut back on proprietary trading as well as their activates as bond dealers. The trading desks are far more reluctant to hold bonds “in inventory” taking some risk when buying or selling bonds to clients. As a consequence when institutional investors see to liquidate bond positions they will find it difficult if not impossible to find ready buyers and will see the prices bid by dealers to purchase these bonds lower than anticipated.

And ETFs fit into the above development as well. The creation of ETFs made possible some hedging of high yield bond portfolios without liquidating specific bonds. A portfolio manager looking to reduce his exposure to high yield bonds could simply sell some ETFs rather than selling off individual bonds. Of course this too is a two edged sword: the ease of trading the ETFs as opposed to the bonds can make investors more short term and increase volatility. Furthermore ETFs can be traded in margin accounts allowing for leveraged trading both long and short. This gives even more potential for wide swings and a feedback loop when the markets reverse direction.

High Yield bonds are not alone in being subject to this negative cycle of selloffs. Emerging market bonds are susceptible and have experienced this as well. Single country funds in emerging market stocks and the new investing fashion of “frontier markets carry these risks as well.

As readers of this blog know I am a big believer that in the long term price reflects value but in the short term markets can overshoot. Or put another way there are both signals and noise in financial asset prices.
It may be early to judge whether the big selloff in the high yield bond market represented a market that now represents value that “overshot” on the downside or that in the big picture this sharp selloff represented “noise” and a buying opportunity. But I wasn’t surprised to see this in the August 16 WSJ

Investors Pour $680 Million Into U.S. Junk Bonds in Latest Week Latest Inflows Snap Four Weeks of Declines
Investors poured $680 million into funds dedicated to low-rated corporate debt in the week ended on Wednesday, according to fund tracker Lipper, snapping four weeks of declines that included the previous week's record $7.1 billion weekly outflow.
Observers pointed to a change in sentiment in early August for so-called junk bonds, as institutional buyers stepped in hunting for bargains. U.S. high-yield bonds lost 1.33% in July, but in August have returned 0.7% through Wednesday

Nor am I surprised to see a price charge like the one below for HYG the ishares high yield bond ETF. The charge below illustrates well the factors I described at work. Note the large price swings, even intraday and the large volume spikes on days of large price moves down.

One more note: never ever enter market or stop loss sell orders in ETFs for this market even on trades in force only for the day. They are almost guaranteed to trigger execution at the most extreme market levels…and those occur far more often on the upside than the downside. On the other hand limit buy orders can allow one to take advantage of short down drafts in these markets.

What does all this mean for high yield bond investing going forward? That will be covered in my next blog article on the subject.

Those losses are manageable and still within the context of normal market volatility. Since the credit crisis ended in 2009, there have been at least five other instances where the high-yield market has corrected more than it has currently. But investors need to have a long term commitment to these markets…they are not for the faint of heart Those moves include:
·         -5.18 percent around Bernanke's taper talk
·         -2.73 percent in May 2012
·         -9.48 percent during the debt crisis in summer of 2011
·         -4.67 percent in May 2010
·         -2.82 percent in January 2010
Although most of the above moves were in the overall level of interest rates and not confined to high yield contrast to 2008 when credit spreads widened to record levels.
U.S. economic growth is showing signs of accelerating, which should offer fundamental support to the high-yield market. According to the median forecast of analysts surveyed by Bloomberg, the U.S. is expected to expand at a 3 percent pace next year. So, a deteriorating economic landscape is not likely to be the culprit behind recent high-yield weakness.

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