Almost exactly one year ago, we penned several articles on what we believed to be a dangerous bubble in corporate debt. The boom in both prices and bond issuance was primarily driven by the desperate “hunt for yield” of investors starved of interest-income by the inane ZIRP and NIRP policies enacted by major central banks all over the developed world.
There is no need to rehash all the arguments we made at the time – as a refresher, readers may want to revisit “A Dangerous Boom in Unsound Corporate Debt” and “Comfortable Myths About High Yield Debt” for the details. So far, the potential dangers we identified at the time haven’t become fully manifest yet, but there are now signs that this may be about to change.
Image credit: Minerva Studio
In fact, there has been a kind of “stealth bear market” in junk bonds for a while already, and it has recently gathered pace in the sector’s worst rated segments. If one looks at a weekly chart of the junk bond ETF JNK (which is depicted excluding coupon payments below – note that one must be careful with charts of bond ETFs, which are often adjusted for payouts and shown as “total return” charts), one could perhaps still argue that it is merely undergoing a drawn-out correction.
A weekly chart of JNK (price only) over the past four years – click to enlarge.
Currently the ETF appears oversold and its price is close to a lateral support level. At least a short term bounce may therefore be in the offing. However, its technical condition certainly looks weak from a longer term perspective. It has already put in two consecutive lower highs and lower lows and has declined quite a bit from its peak.
Curiously, this poor performance doesn’t seem to be getting a lot of attention at the moment. Only a recent article in the FT briefly discusses it, in an attempt to divine whether it represents a bad omen for equities. Interestingly, the author’s answer is “no” – based on the argument that junk bonds are only performing so poorly due to the woes of the energy sector:
“Usually, if you see the yield on high yield rise substantially, it’s a good bet that equities, if they haven’t already, are going to follow,” says Marty Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors. “But here it’s an unusual situation, where the yield is dominated by this one industry.”
Energy companies make up a much greater proportion of the main high-yield indices than they do the S&P 500. Energy company bonds account for 14.3 per cent of Bank of America Merrill Lynch’s Global High Yield index, compared with 7.0 per cent for the US equity benchmark. This reinforces the suggestion that the diverging paths of equities and junk bonds are a result of energy company woes rather than broad market fundamentals.
High exposure to energy “is totally distorting numbers for the high-yield market”, says Sabur Moini, high-yield portfolio manager at Payden & Rygel.
We believe this type of “this time it’s different” rationalization may turn out to be flawed. It is a bit like saying in mid 2007 that “only high yield bonds of sub-prime mortgage lenders are performing badly” and hence there is no reason for concern. The problem with this line of argument is that credit markets are highly interdependent. They always begin to fray in a specific market sector, and often it is indeed a big segment of the market, as the sector most likely to get into trouble first is usually the one that has seen the biggest capital malinvestment excesses during the boom.
The fact that the same is the case in this instance as well is not exactly a good reason to be complacent. Quite on the contrary, it seems to us that this makes the situation especially dangerous. If the market segment doing especially poorly were a tiny one, it probably wouldn’t worth worrying about. However, the segment that is currently in trouble is in fact the junk bond market’s largest.
It isn’t really relevant in this context that the same sector’s equities only represent half as big a slice of the major stock market indexes. Whenever liquidity problems in certain risk asset classes begin to become acute, they tend to spread and eventually will affect otherwise uncorrelated sectors as well – mainly because forced selling to service margin calls usually involves selling whatever one can sell.
A Warning from the Lowest-Rated Market Segment
Let us now briefly look at the effective yield of the BofA/Merrill Lynch US High Yield Master II Index and the yield on the BofA/Merrill Lynch US CCC or Below High Yield Index. Not surprisingly, the former looks essentially like a mirror image of the JNK chart shown above:
BofA/Merrill Lynch US High Yield Master II Index, effective yield. This chart looks bullish – for yields, that is. It appears to be close to a break-out. The advance has already put in a higher low and continues to sport an “impulsive” look – click to enlarge.
In an article we published in early April, entitled “The Era of Return-Free Risk”, we showed a possible Elliott Wave count of the above chart that actually looks quite prescient so far. The chart can be seen here. Although we regard such wave counts as having more descriptive than predictive qualities, the method sometimes yields good results, especially when the fractal shape of a price chart appears very obvious and one has good reason to suspect that market fundamentals will develop in a manner consistent with the forecast derived from it.
However, more interesting may be recent developments in the yields on junk bonds that are rated CCC or lower. The breakout that hasn’t happened in the Master Index II just yet, has definitely already occurred in the lowest rated high yield segments. It seems possible that this is actually a leading indicator for the broader junk bond market:
US High Yield CCC or Below, effective yield. Yields of this segment have already surpassed the peak of late 2014 and have recently advanced to the next short term resistance level – click to enlarge.
When an important market acts badly and this fact isn’t causing much concern among market participants and observers, it is usually high time to pay close attention. In short, we disagree with the conclusion presented in the FT – we believe this is indeed a warning sign for other risk assets such as equities. Let us not forget that the poor performance of junk bonds also ties in with the recently discussed weakening of stock market internals and the soft data on US gross industrial output reported in Q1.
In the short term junk bonds and the weakest stock market sectors (such as assorted commodity producers) are quite oversold and hence seem overdue for a bounce. However, later this year we may actually get to see some fireworks in the markets. Also, keep in mind that if a bounce that “should” happen at this juncture doesn’t happen, it would very likely mean that said fireworks have been brought forward.
This well-known junk bond trader isn’t worried just yet (that’s right, he’s not only a presidential candidate and an honest voice of confusion amid the uncertainty!).
Image credit: Norman Mingo