On Tuesday, Carl Icahn reiterated his feelings about the interplay between low interest rates, HY credit, and ETFs. The self-feeding dynamic that Icahn described earlier this year and outlined again today in a new video entitled “Danger Ahead” is something we’ve spent an extraordinary amount of time delineating over the last nine or so months. Icahn sums it up with this image:
The idea of course is that low rates have i) sent investors on a never-ending hunt for yield, and ii) encouraged corporate management teams to take advantage of the market’s insatiable appetite for new issuance on the way to plowing the proceeds from debt sales into EPS-inflating buybacks. The proliferation of ETFs has effectively supercharged this by channeling more and more retail money into corners of the bond market where it might normally have never gone.
Of course this all comes at the expense of corporate balance sheets and because wide open capital markets have helped otherwise insolvent companies (such as US drillers) remain in business where they might normally have failed, what you have is a legion of heavily indebted HY zombie companies, lumbering around on the back of cheap credit, easy money, and naive equity investors who snap up secondaries.
This is a veritable road to hell and it’s not clear that it’s paved with good intentions as Wall Street is no doubt acutely aware of the disaster scenario they’ve set up and indeed, they’re also acutely aware of the fact that when everyone wants out, the door to the proverbial crowded theatre will be far too small because after all, that door is represented by the Street’s own shrinking dealer inventories. Perhaps the best way to visualize all of this is to have a look at the following two charts:
So now that the wake up calls regarding everything described above have gone from whispers among sellsiders to public debates between Wall Street heavyweights to shouts channeled through homemade hedge fund warning videos, everyone is keen to have their say. For their part, BofAML is out with a new note describing HY as a “slow moving trainwreck that seems to be accelerating.” Below are some notable excerpts:
A slow moving train wreck that seems to be accelerating
For five months in a row now more than 50% of the sectors in our high yield index have had negative price returns. That’s the longest such streak since late 2008 (Chart 1). This isn’t to whip up predictions of utter doom and gloom as in that fateful year. But it’s a stark statistic, highlighting our principal refrain for the last several months – this isn’t just about one bad apple anymore. The weakness in high yield credit is to us not just a commodity story; it is about highly indebted borrowers struggling to grow, an investor base that cannot digest more risk, a market that has usually struggled with liquidity and an economy that refuses to rise above mediocrity.
The problems in the coal sector that began to surface two years ago were perhaps the canary in the coal mine in hindsight. It was easy to dismiss a tiny sector with badly managed companies in a product that was facing secular headwinds as a one-off. But then we had the collapse in oil prices, much more difficult to ignore given the sheer size of the Energy sector in high yield. Barely had the market got its head around the scale of the issue when metals and miners started showing tremors. Now it’s the entire commodity complex.
At this juncture, BofAML has a rather disconcerting premonition. Essentially the banks’ strategists suggest that everything is about to become a junk bond, that corporate management teams will be tempted to resort to fraud, and that a dearth of liquidity threatens to bring the entire house of cards tumbling down:
Around this time last year, when our view on HY began turning decidedly less rosy, the biggest pushback we got from clients was that we were too bearish. A couple of months back, as our anticipated low single digit return year looked likely to come to fruition, many clients began to sympathize with our view, but challenged us on our contention that there were issues beyond the commodity sector. Tellingly, we now have an Ex- Energy/Metals/Mining version of almost every high yield metric we track (it started off as just Ex-Energy last year). Point out the troubles in Retail and Semiconductors and pat comes the reply that one’s always been structurally weak and the other’s going through a secular decline. Mention the stirring in Telecom and we’re told that it’s isolated to the Wirelines. When we began writing this piece, Chemicals and Media were fine, and Healthcare was a safer option; not so much anymore. At this pace, we wonder just how long until our Ex-Index gets bigger than our In-Index.
As Chart 2 shows, the malaise is spreading, albeit slowly. Price action has no doubt been violent over the last twelve months, but it has now started ensnaring non-commodity related bonds too. Over a third of the bonds that have experienced more than a 10% price loss this month belong neither to Energy nor Basic Industries.
Admittedly, over the last few weeks several conversations have indicated a slow acceptance that the turn of the credit cycle is upon us. That however is just the beginning. We suspect that this is the start of a long, slow and painful unwind of the excesses of the last five years.
Along with decompression comes a tick up in defaults, and we expect those to increase in 2016 and 2017. Although a company with a poor balance sheet doesn’t necessarily default, all defaulted issuers have poor fundamentals- and we see a lot of companies with lackluster balance sheets and earnings. The difference why in one environment an issuer survives while in another it doesn’t has as much or more to do with risk aversion and the subsequent conscious decision to no longer fund the company than any change in leverage or earnings. And risk aversion, as noted above, is increasing amongst our clientele. As more investors continue to see the forest for the trees, we believe they will see what we have seen: a series of indicators that are consistent with late cycle behavior that we think clearly demonstrates a turn of the credit cycle.
Finally, there is other typical late-stage behavior that is observable but difficult to quantify. We often see that a cycle is approaching its end when the bad apples start visibly separating out from the pack as idiosyncratic risk surfaces. We saw this first with Energy and Retail, then Telcos and Semis, and now creeping into some of the perceived ‘safe havens’ such as Healthcare and Autos. This is also when company balance sheets that have amassed debt during the cycle start to show visible cracks and investors question whether companies have enough earnings capacity to grow into their balance sheet. Terms of issuance become more issuer-unfriendly and non-opportunistic deals go through pushing new issue yields up. This is also a time when problems surface (Volkswagen), and negative surprises have the capability to cause precipitous declines in stocks and bonds (Valeant, Glencore).
Though we don’t and won’t pretend to predict the next corporate scandal or regulatory hurdle, what we do know is that as cycles become long in the tooth, companies could act desperately.
In addition to a world of lackluster earnings, bloated balance sheets, and worrying global economic conditions, we’re hard-pressed to come up with any client conversation we’ve had on HY over the last 12 months that hasn’t included a tirade on appalling bond market liquidity.
We’ve heard from several portfolio managers with many years of investing experience behind them that this is by far the worst they have seen. Anecdotal evidence from our trading desk also seem to support this view.
We certainly think liquidity is a problem in this market. In fact it was the very reason that our concerns about HY became magnified last fall, as the inability to enter and exit trades easily leads to more volatility and contagion into seemingly unaffected sectors (sell not what you want to, but what you can).
Got all of that? If not, here’s a video summary:
And then there is of course UBS, who has been calling for the HY apocalypse for months. Here’s their latest:
Corporate credit markets have been under significant pressure in recent sessions, with idiosyncratic events erupting across the auto (VW), metals/mining (Glencore), TMT (Sprint, Cablevision), healthcare (Valeant) and emerging market (Petrobras) sectors, respectively. US IG and HY spreads widened 5bp and 27bp, respectively, to levels of approximately 180bp and 675bp, at or exceeding previous wides recorded in 2015.
Here’s our short take: US high grade and high yield markets have suffered under the weight of weak commodity prices, heightened issuance (and the forward calendar), the rally in the long bond, rising idiosyncratic risks and illiquidity limiting the recycling of risk. Lower commodity prices are increasingly pressuring metals/mining and energy firms because prices are so low that many business models are essentially broken. Heavy supply, specifically in the high grade market, is a result of releveraging announcements to satiate equity investors and there have been few signs that management teams are retrenching – effectively setting up a standoff between equity and bond investors where ultimately the path to slower issuance is a broader re-pricing in spreads. Falling Treasury yields have chilled the demand from yield bogey buyers as rates have fallen faster than spreads have widened. Rising idiosyncratic risk, although it arguably is thematically symptomatic of late stage antics where firms are under massive pressure to boost profits (e.g., VW, Valeant), has added accelerant to the fire. And lack of liquidity has made the recycling of risk increasingly difficult.
The prognosis is challenging. Why? Certain aspects are structural in nature; in the later stages of the credit and asset price cycle one should expect greater net issuance from releveraging actions and rising idiosyncratic risk. Further, illiquidity is in effect part of the unintended consequences of post-crisis regulation. However, the outlook for commodity prices and, in turn, Treasury yields is arguably more balanced, but uncertainty around demand, supply and speculative conditions is elevated. But, alas, the primary driver of credit markets remains the same: commodity prices. We believe the market is now reflecting the thesis we have outlined in recent months: lower commodity prices will trigger rising contagion, and weakness will spread to the broader credit markets (in particular lower-quality high yield). Put differently, if commodity prices go lower, index spreads will go wider. This, in our view, is a virtual certainty.
The takeaway from this admittedly lengthy assessment is that between deteriorating fundamentals (e.g. depressed commodity prices), idiosyncratic risk factors, and the very real potentional for cross-sector contagion, the conditions are indeed ripe for, to quote BofA, the “acceleration” of the “train wreck.”
Make no mistake, we certainly can’t imagine a scenario in which an “accelerating train wreck” could possibly be construed as a good thing, but when it comes to HY, the situation is made immeasurably worse by the state of the secondary market for corporate credit and the proliferation of bond funds. If HY collapses entirely and the redemptions start rolling in, it’s difficult to understand how fund managers will be able to facilitate an orderly exit and on that note, we close with the following from Alliance Bernstein:
“In theory, investors can exit an open-ended mutual fund or an ETF at will. But the growing popularity of these funds forces them to invest in an ever larger share of less liquid bonds. If everyone wants to exit at once, prices could fall very far, very fast. A lucky few may get out in time. Others will probably get trampled.”