Bank of America Merrill Lynch’s high-yield team is bearish.
So bearish, in fact that, that they are getting into debates with their clients and colleagues over exactly how bad it is.
“It is our fear that many of the signs we see in high yield ultimately foreshadows further economic and risk asset malaise in 2016 and 2017,” the team led by Michael Contopoulos said in a note Monday.
“However, as we sort through the financial press releases and discuss our views with investors and internally, we realise our disposition is perhaps on the unconventional side of where most currently sit.”
The firm first tackles the argument that they are too bearish and that the problems in the high-yield market are isolated to energy.
“Never was the ‘problem’ just with Energy, as Metals and Mining and non-food Retail had been reeling for some time. As the year waned, the weakness spread to isolated pockets of Wireline and Technology, then Wireless, Chemicals, Pharma and Cable.”
Next up, there are some that argue that because the problems are energy related, the market is “cheap.”
Once again, WRONG!
“One can’t say that overall market yields or spreads are cheap, inclusive of commodity paper, and then say that the issues outside of commodities are few and far between,” the note said.
Spreads on bonds rated double B issued by companies outside the commodity sector are around 350 basis points, according to the note. The only time they have been tighter in the last 16 years was in the pre-crisis debt boom from late 2003 to late 2007. Not cheap, in other words.
An employee walks through the Petrolchemie and Kraftstoffe (PCK) oil refinery in Schwedt/Oder, October 20, 2014.
“So the argument that spreads are cheap and that the market trouble is isolated to commodities is not only inconsistent, in our view, but grossly misrepresented,” the note said.
Then there is the argument that these yields compensate investors for the risk of default. You guessed it. Nope.
“Not only are spreads not cheap from a historic perspective, but in our view, there is no question that defaults are going higher in 2016 and that investors are not being compensated for an increase in credit losses.”
Lastly, there is the argument that higher yields — market yields are now around 9% — will lead to inflows into the asset class. Contopoulos and his team argue that while retail investors are unlikely to allocate cash to high yield, institutional investors might.
But here is the thing: this won’t actually have an impact. There is expected to be $200 billion of issuance (or new bonds) coming to market this year, and this will likely sop up any new incoming cash.
“Despite our view that institutional money shouldn’t be transitioning into high yield, should they do so anyway, the amount of capital that could find its way into the asset class in the context of issuance, downgrades and retail outflows could be irrelevant,” the note said.