The Upcoming Correction In HY Debt Prices

The surprisingly resilient HY and IG market over the last two months (and the reason why so many hedge funds outperformed benchmarks) is starting to crack. We have discussed how purely fundamental assumptions about recoveries in the upcoming wave of defaults will likely reprice risk substantially lower, however a mere glance at existing technicals imply the HY market, especially the single B rated tranche and single names, will soon experience a drubbing.

One of the indicators to watch is the BofA subindex of IG financial bonds, which has dropped recently to post-Lehman wides (the recent move of Citi CDS to points up front is very indicative of the fear in the financial market). Curiously, as fear and loathing has spread among IG financials, the broad HY master index has continued to trade in the low 1,600s after peaking around 2,200, although on Tuesday and Wednesday it did drop lower and is currently in the mid 1,700s.

The paradox is that despite significant weakness in both higher and lower ranked asset classes (IG and equities), HY has been rock solid. The recent widening in IG Financials spreads puts the HY recovery at risk. This is even more evident from the next chart, which shows that HY credit spreads are among the narrowest in the credit space, with Single B spreads trading the tightest (73%) in terms of post-Lehman wides, compared to 98% for IG Financials. There is little chance of leveraged corporates surviving unscathed as the too big to fail companies are seeing a rapid increase in market risk. The HY correction is further justified when compared to the ongoing weakness in equities. In summary, the equity markets are down 20% YTD, while HY is up 2.5%. Over the last year, the correlation between the two markets has been 91%, which implies HY spreads are trading at 2.5x sigma deviation from implied levels. The gap can and will only close through either a strong rebound in equities or a 20% widening in HY spreads. Investors can decide which is more realistic.