Never mind Hong Kong protests, Pimco’s palace intrigue or violent clashes in the Middle East. The crucial influence on our markets now is what investors are willing to pay for junk.
The high-yield, or junk bond, market has been the pounding heart of the bull market, pumping the cheap liquidity created by central banks through the corporate economy, attracting billions from income-parched investors, enabling generous corporate share buybacks and making stocks look attractive in comparison.
That’s why the recent bout of nervous selling in high-yield debt has got the stock market fibrillating in the six trading days since the Standard & Poor’s 500 index hit an all-time high a week ago Friday.
The junk-bond spread is the amount of extra yield investors demand above Treasury securities to compensate for the risk lower-rated issuers might default. This spread, while still quite tight versus history, weakened to its widest levels of the year Friday, according to bond strategists at RBS. At 4.62 percentage points above comparable Treasuries, the spread was up substantially from 4.08 points at the end of 2013.
Edward Marrinan, credit strategist at RBS, has been telling clients since early this year that the spread-tightening trade has delivered all it was likely to offer, and junk was best viewed as a source of “carry” – that is, extra yield income over less risky debt.
What’s interesting is that the recent backup in rates appears most connected to faltering risk appetites and a sense that the added yield might not be worth the bother if indeed the Federal Reserve is poised to cinch short-term rates higher early next year.
This is what appears to be behind the heavy outflows from high-yield funds, in particular the large exchange-traded funds that have become a primary way retail investors access the junk market. The iShares iBoxx High Yield Corporate Bond (HYG) and SPDR Barclays High Yield (JNK), have suffered outflows, and their prices are at the lows of the year. Outflows force the ETFs to sell bonds into a relatively illiquid market, which can cause price disruptions across the asset class.
Many investors monitor the HYG and JNK for clues to credit-market conditions, but they are noisy indicators at best. Because they are prone at times to rally or decline as Treasury yields fall or rise, and make all fixed-income assets more or less valuable (all else being equal), their prices don’t cleanly indicate junk-investor behavior.
Two upstart ETFs are meant to deliver a more direct play on the credit component of high-yield debt, stripped of interest-rate influences. The ProShares CDS North American High Yield Credit (TYTE) and ProShares CDS Short North American High Yield Credit (WYDE) contain credit-default-swap instruments which track the pricing of only the credit piece of a junk index.
Let’s be clear: These are infant funds with tiny asset bases, little trading volume and a strategy of using derivatives to track an over-the-counter market. This isn’t an endorsement of the strategies, but the price action in WYDE (get it – “wide”?) shows how rapidly credit markets have gone wobbly.
The ETF – which gains when credit markets grow more fearful – is up 2.5% since Sept. 2, a pretty significant short-term move for the corporate-credit market. This makes it a good signal to gauge credit effects on stocks.
The small-cap factor
The most direct way unease in credit markets is conveyed into equities is to clip small-cap stocks. Smaller companies are more dependent on borrowing, and their shares are direct beneficiaries of rising liquidity and risk appetites. So it’s no surprise the iShares Russell 2000 (IWM) is off 5.5% since Sept. 2 and is trading not far above its midsummer lows.
As noted here last week, the recent spell of tetchy market action looks pretty similar to what happened in July and August, with below-the-surface weakening in small stocks and credit markets belatedly recognized by Wall Street once the S&P 500 began a “catch-down” move.
This suggests the month-long sloppiness in smaller stocks and junk debt could mean this corrective phase has gone further along than those blinded by recent all-time highs in big stock indexes might recognize.
There is some irony in junk debt suffering weakness as investors prepare for an eventual shift in Fed policy, because for years this asset class was touted as having less interest-rate sensitivity than safer, lower-yielding fixed-income categories. This is usually true, but in the transition away from ultra-easy to slightly less easy Fed, investors seemingly are selling in advance, feeling it’s not the time to stretch for just a bit of extra income.
As important, supply of new junk debt earlier this year may have overwhelmed, and the market needed to re-price. As this led to fund outflows, the market itself has been too thinly traded to accommodate comfortable exits. Many saw this coming, as this Yahoo Finance piece from June 2013 shows – a result of a less-liquid bond market due to new regulation and Wall Street structural changes.
In a noteworthy (if self-serving) report last week, asset manager Babson Capital published a paper pointing to the drawbacks of owning junk debt through passive index ETFs because they are vulnerable to technical selloffs without having the flexibility to take advantage of them. The firm suggests credit fundamentals remain pretty stable, with default rates ticking only modestly higher from extremely low levels and company debt-coverage ratios reasonably healthy.
Yet bursts of fund redemptions can exacerbate market selloffs now that high-yield ETFs account for more than 11% of retail mutual fund assets in the category, up from essentially zero in 2007. Babson’s point is that active managers, such as Babson, can step in and exploit such market dislocations in a way ETFs can’t.
This view, on one hand, is reassuring, implying that it's merely “weak hands” among small investors selling out of junk debt clumsily, rather than the credit markets “sniffing out” more profound economic difficulties ahead.
Yet an alternate take is that this is the very type of activity that can result in “financial accidents,” flurries of forced selling that spreads to encompass other asset classes.
Most financial panics have in common “crowded carry” trades (too many people borrowing to buy the same stuff to goose returns) and “liquidity mismatches,” when a fund or other vehicle offers investors faster access to their money than the underlying securities can provide.
Without being alarmist, these characteristics seem somewhat to apply to the junk market.
If the high-yield market settles itself after this bout of anxiety, stocks will likely also find their footing. This is why equity investors might be up at night pondering whether big-money investors will now regard a 6%-yielding junk index as a pretty good buy, or whether our Fed or the Chinese central bank might soon do something to reawaken the liquidity-backed yield grab – or not.