The astounding rally in the high-yield corporate bond market (i.e. junk bonds) over the past two months has finally hit a bit of a wall alongside a stall in the broader rally in risk assets (e.g. stocks).High-yield bond ETFs were hit particularly hard last week with redemptions, recording the largest weekly outflow ever.
Depressed yields on safer investments like U.S. Treasury bonds have moved investors further out on the risk spectrum in search of interest income. The high-yield debt market is pretty far out on the spectrum and is usually one of the first places you will start to see general market sentiment turn. This owes to its relatively high sensitivity to changes in risk perception and the large amounts of retail money that have piled into high-yield funds since the financial crisis.
BofA Merrill Lynch strategists Oleg Melentyev and Neha Khoda write in a note to clients that the market is becoming increasingly unstable at these levels:
This most recent pullback signifies how unstable the market is becoming at its current valuations.
To borrow the term from aerodynamics, we view these levels as forming the “coffin corner” for high yield, a term referring to the altitude at which an aircraft becomes nearly impossible to keep in stable flight. It defines the situation, where the current speed is both the minimum required to maintain level flight and at the same time also the maximum speed at which air can travel over wings without losing lift.
Such a combination does not affect planes flying at normal altitudes, but applies to those ascending to critically high levels, often exceeding 60 thousand feet. This reminds us of a place where the high-yield market finds itself today – a point where the positive momentum is required to maintain continued demand for the asset class, and yet producing such positive momentum would imply pushing the market valuations further beyond any reasonable levels, thus undoing the very reason for being aggressive in buying risk at these levels.
An unstable combination, in our view.
Melentyev and Khoda cite strong primary issuance into a weak secondary market and investor jitters over how much duration risk they have taken on in their portfolios as key headwinds for the high-yield market right now.
The BAML strategists suggest that the next big market catalyst could be in late March, when they believe a “tipping point” will occur in Washington, D.C. fiscal negotiations. Before that, the market could continue to move higher.
However, they warn, “This push could prove futile at the end, in our opinion.”
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