The high-yield market has bounced back in a big way since the sharp sell-off earlier this year.
That doesn’t mean all is well with the market, however. In fact, the more stable conditions could just be a temporary reprieve.
We noted commentary yesterday from Matthew Mish, credit strategist at UBS, raising concerns over an increase in the default rate among high-yield bonds.
In addition to the short-term factors that Mish believes will lead to more defaults, the strategist also highlighted a key concern among investors over the composition of the bond market.
Here’s his breakdown (emphasis ours):
Holdings of corporate debt are increasingly concentrated in ‘less stable’ hands. In a rising default environment, mutual funds, ETFs and foreign investors are more likely to liquidate holdings than pension, life insurance, private equity and hedge funds, and forced selling could cause significant price volatility, and this in turn could lead to major redemption issues, given that 55% of the HY market (proxied by the Citi HY index) and 36% of the Leveraged Loan market (proxied by the S&P Leveraged Loan Index) are held by funds with major outflow risk, up from 45% and 19% in March 2009.
The main thrust here is that “tourist” investors are including risky high-yield debt in their portfolio in order to generate returns they can’t find elsewhere. These investors, however, are not as likely to stick with the assets if they start to slide.
The concern is that that will create selling pressure, as fund managers rush for the exits all at once, and that due to post-crisis regulation there will be no one there to catch the market as it falls.
Steve Schwarzman, CEO of private equity giant Blackstone, highlighted this risk on Thursday, saying that Dodd Frank regulation had made the world a little less safe.
“So, when they passed the Volcker rule, there were 25 firms making markets in junk bonds. Guess how many there are now?” said Schwarzman at the Bernstein Thirty-Second Annual Strategic Decisions Conference 2016
“Five. That’s 25 to 5. Triumph? You decide. OK. So, what happens when things get difficult, that market now just locks up. That is not healthy for the capital markets.”
So what do you get when you have a risky asset class, jittery investors, and a smaller pool of firms standing ready to pick up the pieces if it starts to fall apart?
Based on Mish and Schwarzman’s assessments, nothing good.