Is The Junk Bond Bubble Bursting Before Your Very Eyes?


Ok, properly it appears like excessive yield is lastly beginning to crack.

I gave it per week (truly greater than per week) earlier than I made a decision to write down about it once more in these pages just because I have been fairly exhausting on junk bonds in my posts on this platform, nevertheless it’s changing into fairly tough to disregard.

As common readers are acutely conscious, I’ve a deep-seated aversion to excessive yield ETFs like iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK).

In some ways, the setup there’s something akin to the worst case state of affairs, and never as a result of there aren’t extra harmful issues on the earth, however moderately as a result of lots of people refuse to acknowledge the inherent absurdity within the mannequin.

I need to make this a comparatively quick put up, which suggests not getting too far into the weeds on the liquidity subject, however what I need to reiterate is that this essential level: when individuals are made conscious that one thing which they took at face worth is actually nonsensical, those self same individuals are detest to acknowledge the issue. And it isn’t as a result of they do not perceive the argument – certainly, with excessive yield ETFs the argument is so easy that somebody with no market acumen in anyway might perceive it. You cannot supply intraday liquidity in opposition to a bunch of belongings that are not liquid. That does not work. That mannequin is unnecessary and no argument about unit creation/destruction, or “volume”, or “velocity”, or an more and more “well-behaved” NAV is ever going to vary that, as a result of the concept that you could supply intraday liquidity in opposition to an underlying pool of illiquid belongings is a philosophical impossibility.

That solely works so long as the flows are diversifiable (i.e. one supervisor getting inflows as different managers get outflows). If the flows grow to be unidirectional, it does not work anymore and the liquidity of the ETFs converges on the liquidity of the underlying bonds. And that is sensible as a result of in any case, the ETFs signify an funding within the bonds. There isn’t any method round that.

I wrote a hilarious piece on this for DealBreaker lately that features a cameo by everybody’s favourite claymation icon Gumby – you may learn that right here. But along with my arguments, simply know that if you don’t imagine me after I let you know that the mannequin does not make sense, simply know that I am in good firm on that time – firm that features Howard Marks and Carl Icahn.

Ok, so provided that setup, what you do not need to see is the excessive yield bubble beginning to burst, as a result of the nearer we get to that, the nearer we’re – by definition – to a state of affairs the place the liquidity of the ETFs begins to converge with that of the underlying bonds.

Well this month, issues are getting dicey. JNK has fallen for seven consecutive clbades and has dropped beneath its 200-day MA:

Make no mistake, that is changing into a sizzling matter. Just ask Jeff Gundlach, who has been tweeting about fairly a little bit of late:

There are so many points at play right here that documenting them is tough, however at a excessive degree, do word that spreads have after all been pushed to post-crisis tights as a consequence of the central bank-engineered hunt for yield. Over the final couple of weeks, we’re widening out. Bloomberg Barclays High Yield Index spreads closed at +350 on Wednesday after hitting a Three-year low of +326 October 24:

Here’s that chart put within the context of what Gundlach is speaking about:

Stocks (SPY) rising, however HY spreads blowing out. As Jeff places it, somebody needs to be “wrong.”

Documenting the current selloff on Wednesday afternoon, Bloomberg famous that there isn’t a “discernible cause.” And whereas I suppose that is some semblance of true, it is also an odd factor to say in gentle of the truth that spreads have grow to be utterly disconnected from leverage. In different phrases, there’s an inherent disparity on this market and ultimately, that is going to should kind itself out. Moody’s warned about this in late September as follows:

The current composite high-yield bond unfold of 367 bp is much more badured of a benign outlook for defaults than is the typical high-yield EDF metric. Nevertheless, the final thrice company debt approximated 507% of inner funds in Q2-2008, Q2-2000, and This fall-1989, the high-yield bond unfold averaged 646 bp. More particularly, the high-yield unfold’s quarter-long averages have been 675 bp in Q2- 2008, 631 bp in Q2-2000, and 632 bp in This fall-1989. (Figure 2.)


Moreover, the US high-yield default charge is predicted to drop from This fall-2016’s 5.6% to three.2% for This fall-2017 and, then, to additional subside to 2.eight% by Q2-2018. However, a rising ratio of debt to inner funds usually leads the default charge greater. The quarter-long common of the US high-yield default charge exhibits very important correlations of zero.80 to zero.83 with the ratio of debt to inner funds from one to 3 quarters earlier.

There are additionally some jitters in regards to the extent to which HY could be affected by a change within the remedy of curiosity expense tied to the brand new tax plan. Here’s BofAML on that:

Interest expense deductibility is essentially the most related subject for HY market members. Interest bills could be allowed as much as 30% of adjustable taxable revenue, outlined consistent with EBITDA. Based on newest reported numbers, we estimate slightly below 40% of US HY market is uncovered to names with curiosity bills exceeding that threshold over the previous 12-months (37% of issuers and 39% of debt).

You must also word that the divergence between shares and junk isn’t one thing that is commonplace. Here’s an fascinating (if largely meaningless) tidbit from a chunk WSJ ran yesterday:

While losses have been comparatively small, the divergence between falling high-yield bond costs and U.S. shares at information is uncommon. Only one different time since HYG launched in 2007 has the S&P 500 hit an all-time intraday excessive, because it did Tuesday, on the identical day that the HYG fell to its lowest degree in no less than a month, based on Jason Goepfert, founding father of Sundial Capital Research.

At the very least, you must control this as a result of for fairly a while, these of a skeptical persuasion have been asking if junk would find yourself being the canary within the coal mine. If that canary is singing, you must in all probability hear.

In the identical Moody’s word excerpted above, the rankings company lampooned the disconnect between spreads and leverage as follows:

In a world the place company bond yield spreads slim regardless of steeper leverage, pigs simply may fly.

Right – “pigs just might fly.”

Or perhaps they “might” not.

Because as Jeff Gundlach tweeted whereas I used to be scripting this put up, the early buying and selling in shares on Thursday instructed that JNK was “right”:

Disclosure: I/we’ve no positions in any shares talked about, and no plans to provoke any positions inside the subsequent 72 hours.

I wrote this text myself, and it expresses my very own opinions. I’m not receiving compensation for it (apart from from Seeking Alpha). I’ve no enterprise relationship with any firm whose inventory is talked about on this article.

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