Crazy for Yield
A case of bad timing …
Cartoon by Eric Allie
In one of those markets definitely not distorted by central bank policy (see “Bernanke’s Apologia” if you’re wondering what that is about), an outbreak of craziness has just been spotted by CNBC. We are informed that investors are “jumping into junk bonds”:
“The supply of U.S. companies with junk-rated debt is rising just as investor demand for higher yields is climbing.
Moody’s reports a two-year high in company debt rated B3 negative or worse—a.k.a. junk—as part of a trend that has seen the list of 184 companies grow by 26 percent over the period. The rise has been led by oil and gas firms, which accounted for 12 of the 28 additions to the junk list in February.
What’s more, the roster would be even longer but for companies falling off the list due to reasons including filing for bankruptcy. Of the 18 issuers no longer rated, 39 percent filed either for bankruptcy protection or “distressed exchange, and 33 percent withdrew, with just 28 percent getting off the list due to upgrades. This is a reversal from the previous two quarters, when most companies left the list via ratings upgrades,” Moody’s said. “If this reversal continues, it could signal tough times ahead for speculative-grade issuers.” Not so far, though.
Fueled by low default rates and generally favorable credit conditions, investors in 2015 have been pouring money into funds that invest in high-yield debt. In fact, the previous six weeks before the most recent week had the highest level of flows to junk funds since the financial crisis in 2008 and 2009, according to Morningstar.
Flows to junk-focused funds have taken in a net $12.2 billion so far in 2015 as part of a broader interest in fixed income amid a turbulent stock market, Bank of America Merrill Lynch reported. In addition to the big cash attraction to junk, high-grade bond funds have seen net inflows of $36.4 billion.
The sentence about “companies falling off the list due to bankruptcy” is actually quite funny in this context. This sure hasn’t fazed the herd of greater fools just yet. We already discussed the fact that loan covenants have gone the way of dinosaurs in a previous post, but below is a reminder via the CNBC article. This in turn is enticing soaring issuance of junk debt:
In exchange for the alluring yields of junk bonds, which are currently about 6.1 percent on average, investors are sacrificing protection against defaults. Covenant quality, or the types of restrictions placed on issuers for financial practices after issuing the bonds, is at record low levels. Moody’s rates covenant quality on a scale of 1 to 5, with 1 being the most restrictive and 5 the least. In February, the average covenant score for all new bonds was 4.51, worse than the previous apex of 4.43 in November. The tolerance for weaker restrictions on practices such as taking on more debt or making risky investments represents an increase in faith that may not be justified when the bonds hit maturity.
Junk-grade companies are taking advantage. In a typical month, so-called high-yield lite junk bonds account for about 20 percent of total issuance of companies that Moody’s covers, according to Friedman. However, since September, the total has been closer to 40 percent, with February’s at a robust 46 percent during the same month when covenant weakness peaked.”
Modern investing in “non-distorted markets”
Cartoon by Joscha Sauer
What is interesting about this unseemly rush into junk rated debt by investors is the fact that it is actually diverging a bit from the sector’s performance. The troubles in the oil and gas patch have left their mark, but junk bond yields started to rise even before this particular sector came under pressure.
Below is a chart of the Merrill Master Index II effective yield, with a tentative Elliott wave labeling of the move off the all time low made last year. We are aware that according to the rules, wave 4 should not enter the territory of wave 1, but there are other junk bond yield indexes in which it actually doesn’t, especially spread indexes such as the Barclay’s US corporate high yield spread index, which incidentally also exhibits a somewhat larger third wave. So take the labeling of this chart only as a proxy. If the idea should turn out to be correct though, junk bond yields could rise quite a bit from here. We hasten to add that this has to be taken with a spoonful of salt (our convictions regarding the method’s predictive qualities are modest, but the clearer the pattern, the better it usually tends to work).
Merrill Lynch High Yield Master II Index, effective yield. The recent pullback in yields (= rise in prices of underlying bonds) has been enough to entice investors to put record amounts of money into junk bond funds and ETFs. This actually represents a bearish divergence, as the low in yields was made some 9 months ago already – click to enlarge.
Undeterred Experts amid Small Glimmers of Concern
Neither the sudden scarcity of loan covenants, nor record junk bond issuance or the looming threat of rate hikes by the Fed (admittedly still a remote threat) or recent weakness in economic data have been able to deter experts from advising the herd to buy more. There is an exception though: Rating agency Fitch has warned that investors could be asking for trouble by buying at this particular juncture (see further below). Here is an example of the typical rather sanguine expert:
“We continue to expect the high-yield market to outperform investment-grade for the remainder of the year,” David Sekera, corporate bond strategist at Morningstar, said in an analysis of the sector. “Based on our expectation that GDP growth in 2015 will range between 2.0 percent and 2.5 percent, macroeconomic fundamentals in the United States should be generally supportive of credit risk and dampen defaults through the rest of the year. The combination of modest economic growth and low interest rates should keep default rates from rising meaningfully this year.”
Someone said “jump” and so we jump …
Cartoon by Matt Wuerker
This reflects essentially the consensus expectation on GDP growth this year, and of course neither recessions nor increases in default rates are usually anticipated by the consensus. Default rate expectations are as a rule at their lowest precisely at the same time when yields are hitting their lows. They are therefore essentially useless as an indicator of future conditions, unless one uses them as a contrary indicator. What if all those rosy GDP forecasts don’t come true and the economy enters a recession? Economists have already missed (and funny enough, by and large continue to miss) what happened in the first quarter by a few light years:
The Atlanta Fed’s GDP Now forecast, which is constructed exclusively on the basis of data. The consensus of economists is currently in a different galaxy.
Admittedly, in light of the many data points that have missed expectations of late – the most recent example was provided by a batch of “ugly numbers out of Texas” as Bloomberg puts it – one should normally expect a counter-trend move during which expectations are beaten for a while, as they have presumably been lowered by now in reaction to the recent misses. This makes it easier to achieve beats.
The “economist consensus expectations” game has some similarities to Wall Street earnings expectations in this sense. However, there is of course one crucial difference, namely that earnings expectations will always be beaten. Regardless of how awful earnings actually are, a string of misses is as good as impossible, as the hurdle will always be set low enough to enable “beats” just prior to the reporting period.
Having said all that, if the weakness of the economy was not only due to bad weather (somehow, the weather always manages to be bad in wintertime, perhaps because of “global warming”), it is possible that recent trends will actually persist and the economy will get worse. In that case, consensus expectations about this year’s growth rates and consequently junk bond default rates will turn out to be very much misguided.
Here is a brief video in which Fitch analyst Ed Eyerman voices concerns about junk debt and the future of the global economy in light of lower energy prices. As he notes, there has been a lot of investment in unproductive sectors, and he actually goes as far as comparing the current situation to 2007. He also points out that it is quite erroneous to believe that market confidence was any different in 2007 from today – in spite of the beginning mortgage credit crisis, confidence in junk debt and other risk assets actually remained sky-high for most of the year (recall the widespread conviction that the sub-prime crisis was “well contained”):
Ed Eyerman thinks the current situation is actually reminiscent of 2007
Wherever one looks, caution is being thrown to the wind. This is especially obvious when contemplating what are normally considered the riskiest market sectors. Whether it is the bubble in mostly money-losing biotech and social media stocks (we will discuss these sub-bubbles soon in a separate post) or junk debt, investors seem completely oblivious to risk. In Europe one can now “lose money safely” in about $2 trillion worth of government bonds, and if that is considered too boring, one can always bet on junk that yields less than in about 98% of recorded history. As an aside, we wouldn’t be terribly surprised if the bubble in euro area sovereigns eventually ends with a crash. One thing is certain though: If ever there was an era of return-free risk, this is it.
Charts by: St. Louis Federal Reserve Research, Atlanta Federal Reserve Research