The credit clock is ticking and the time for high yield investment may nearly be up, according to Citi’s Matt King and Hans Lorenzen.King and Lorenzen believe that, based on the balance sheet status of corporations, the credit cycle is clearly moving forward leaving behind the opportunities for high-yield bond investors.
Putting together the anecdotal information and the statistics, in US high grade, the bondholder-unfriendly stage of the leverage cycle seems only a few quarters away. The pick-up in M&A is US specific (with European companies still being more cautious), and in high yield we are less concerned in any case. But the workings of the leverage clock therefore mean that the underperformance of credit relative to equities, which began in March, is probably only a foretaste of further underperformance to come (see Figure 49). It is not so much that we expect a violent turnaround; it is simply that we see little reason to chase the market here, and quite a few reasons to lighten up.
Notably, King and Lorenzen also believe that the credit rally will be damaged by the end of QE2. They don’t think there is going to be a selloff, but rather that continued weak economic data will result in a lack of demand.
It is not so much that we think the end of QE will spark an instant sell-off. Rather, we think the market will be coming off drugs, which meant that sizeable market inflows found simply nothing to buy. If the headlines revert to being positive, then spreads should hold in regardless. But if, as we suspect, they continue to disappoint, investors may find themselves rather shorter of breath than they were when the market was at its peak. For now, we think this rally is running out of steam.
This isn’t in direct opposition to others, like Albert Edwards, that believe treasury yields will fall and stocks will plummet as a result of the end of QE2. It seems, however, that high yield bonds will be under similar stress to stocks in that scenario.
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