Junk bonds are in the news again as rates rise, funds liquidate or restrict investor redemptions, and fear grows that 2016 could be a year of rising defaults in the high yield bond market.
That’s got many on Wall Street worried that this is a signal of impending market doom.
Worse still, some see the pressure in high yield bond markets as foretelling a recession for the US economy.
That has driven the Barclays US high-yield corporate bond index to 389bp above the low reached in June 2014, as Christopher Wood, author of CLSA’s well regarded Greed and Fear newsletter, noted over the weekend.
A large part of this weakness has been due to the impact of a collapsing oil price on perceptions of company health and the knock-on impact on the high yield (HY) debt that companies in the energy sector have issued.
The weakness has infected the junk bond market as a whole. That prompted Goldman Sachs to release a note earlier this month saying “2015 could become the worst non-recession year for HY.”
CLSA’s Wood says the pressure doesn’t appear set to dissipate any time soon, and redoubled his call for $20 oil.
It remains remarkable more than one year after the oil collapse began how little US production has come down as the marginal cost of shale continues to decline. Thus, US crude oil production peaked at 9.61m barrels per day in early June and has since fallen by only 4.5% to 9.18m last week. It also remains hard to see why anyone should expect OPEC pricing discipline to be restored when Saudi Arabia and Iran are engaged in a war via proxies in the Middle East.
But even against that backdrop it’s not all bad news according to Jim Casey, J.P. Morgan’s global head of debt capital markets. Casey, who has carriage of Morgan’s high yield bond operations as part of his remit, told the Wall Street Journal that he is far from negative on the sector.
“We don’t believe the market is in a bubble. We don’t believe the market is overvalued… you can still make good money in high yield,” Casey said.
But Casey also says the market has yet to find bottom. That is: junk bond rates might have further to rise. “We do need to get some stability in the market to clear all of this paper. We don’t have stability right now,” he said.
That’s particularly the case given there are a number of deals on bankers’ books which need to be closed for year’s end. In the short run that implies further upward pressure on high yield spreads as the books are cleared.
Casey told the Journal that after the Third Avenue Management high yield fund recently put a stop to investor redemptions, he asked his traders and sales people for a health check on other funds. The responses said that no other funds were similarly vulnerable. Rather, these funds reported that they had liquidity and could handle redemptions.
That assertion of invulnerability may be tested, though, with strategists at Bank of America Merrill Lynch saying that the outflows are causing bond carnage.
Bond funds saw $13 billion (£9 billion) in outflows last week, the most since June 2013, BAML said.
In a separate report the FT says that’s pushed total cumulative flows from Junk bond funds in 2015 back into deeply negative territory.
The selling that may accompany redemptions amplifies concerns about junk bond market liquidity.
The FT also reports that two benchmark junk bond exchange traded funds run by two of the globe’s largest money management firms, one by Blackrock and the other State Street, moved more than 1% up and down almost every day last week.
That’s the kind of volatility you get when markets are thin and traders are struggling to find liquidity.
Christine Todd, head of tax sensitive and insurance strategies at Standish, the fixed income arm of Bank of New York Mellon, told the FT that “there are a lot of tides that are conflicting and moving and it’s very hard to predict how that will impact markets, prices and investor behaviour.”
As J.P. Morgan’s Casey suggested, there is likely value in these bonds somewhere. But for the moment investors are clearly spooked as the junk bond market tries to find bottom.