"What's even more dangerous than the actual stock market is the high yield market,” Carl Icahn (who is perhaps talking his book) recently warned, before saying he “feels sorry” for all of those throwing their money into junk bonds in a desperate search for yield. We have of course long warned that a half decade of easy money policies have had the unfortunate side effect of allowing otherwise insolvent companies (most notably energy producers) to stay afloat by keeping rates artificially low, thus creating demand for HY debt while simultaneously ensuring that borrowing costs for issuers remain (very) favorable. Indeed, HY issuance is quite clearly correlated with successive rounds of QE as the following charts show:
More specifically, UBS notes that “the picture is crystal clear: In both periods, issuance was $130bn more than average, or about 50% greater than the average amount expected, over an 11 month period. The main drivers were lower yields, sharp drops in yields (we find that the speed of yield changes plays a significant role in impacting issuance), and strong inflows.”
Over time, this has had the effect of, in Citi’s words, destroying creative destruction by creating a legion of zombie companies which have continued to produce when they likely should have been long buried, contributing to a global supply glut and ultimately, to deflation.
Unfortunately, this dynamic will persist as long as the Fed keeps rates suppressed, as investors have virtually no alternative but to look for yield wherever they can find it, especially when many risk-free assets have a negative carry. It’s no surprise then that Bloomberg is out calling junk bonds “the new haven asset”:
The new fixed-income haven is, of all things, the market for junk bonds.
With government bonds in Germany to Japan yielding less than nothing, money is pouring into exchange-traded funds that buy speculative-grade debt, traditionally the riskiest of fixed-income assets.
The pace is staggering. So far this year, about $9 billion has flowed into the funds globally, a significant chunk for the $44.4 billion market in junk-debt ETFs.
In the land of negative yields, even the most conservative firms such as Zurich Insurance Group AG and Assicurazioni Generali SpA, the biggest Swiss and Italian insurers, are planning to invest in sub-investment grade debt for the first time. One of the bond market’s brightest luminaries, Jeffrey Gundlach, says you’re better off in junk because the only money to be made on German bunds is from betting against them.
While last week’s sudden selloff in euro sovereign debt gives investors all the more reason to crowd into high-yield assets, the lingering concern is that buyers are exposing themselves to even greater losses. And with the European Central Bank’s bond purchases still keeping government yields close to historic lows, many bond investors have few other options.
“Investors are being forced by the central bank to assume more risk,” Jens Vanbrabant, a money manager at ECM Asset Management, which oversees $6.5 billion, said from London. “They’re trying to adapt their investment parameters to the new situation of zero or negative yields.”
While all of this may be true, the simple fact is that HY is HY for a reason — from a fundamental perspective, the issuers are not as sound as their IG counterparts. Combine this with the fact that in a pinch, HY will be the first to suffer and holders will be selling into a secondary market with no liquidity, and you have a scenario that could quickly turn into a rout. This is especially true for HY energy names which, as Barclays notes, look particularly overbought:
High yield E&P bond prices have disconnected with commodity prices. High yield E&P bonds have been among the best-performing sectors in high yield, up 6.4% YTD through April 27, compared with a 3.9% return for the overall high yield market. At a current yield of 8.9%, the HY E&P sector presents a 300bp pickup to the high yield market’s 5.9% yield, but well below the 469bp premium offered on December 16, 2014, when WTI oil prices hovered $2/bbl above current levels (chart).
Management teams have been quicker to respond to the downturn, so we continue to expect defaults to be modest in 2015, but they could accelerate in 2016 if oil prices do not rebound. High yield producers have cut costs aggressively, lowered spending by over 40% y/y, and have aggressively raised capital. Year-to-date, new issuance in High yield energy has been robust, with $15bn through April 9, 2015, compared with an average of $9bn in 1Q over 2007-14. Equity issuance has also been strong, with over $11bn YTD from all North American independent oil and gas producers.
We think there are four main risks to investing in HY E&P bonds today. First, we do not think debt/EBITDA of over 4x is sustainable in a capital-intensive industry. In our coverage universe, we forecast that over one-third will have leverage above 4x in 2015. Second, about 42% of the high yield peer group’s 2015 production is hedged at oil prices of $88-92/bbl, providing downside protection this year but negative cash flow decrements in out years absent material price or production gains. Third, we think there is risk to priming of unsecured bonds with secured debt. As we and our credit strategy colleagues discussed in Don’t Get them While They’re Hot, April 10, 2015), we think more producers will look to first- and second-lien issuance to shore up balance sheets, which in most cases has led to significant underperformance of existing bonds given priming concerns. Finally, if equity prices begin to reflect valuations closer to current strip prices, bond performance could also be negatively affected, given the high correlation between high yield bonds and equities, especially for higher-beta producers.