High Yield

There is a war being conducted out there in the financial markets. A war between debtors and creditors, between governments and taxpayers, between banks and depositors, between the errors of the past and the hopes of the future. How can investors end up on the winning side ? History would seem to have the answers. We would argue today that central bank bubble-blowing has made the entire market high-risk, with a broad consensus that with interest rates at 300-year lows and bonds hysterically overpriced and facing the prospect of interest rate rises to boot, stocks are now "the only game in town". If history is any guide, the identity of the losers seems to be self-evident.

Low volatility is being driven, in BofAML's view, by both fundamental and technical factors. Fundamentally, the volatility of real economic activity and inflation has fallen to near 20 year lows in what some are calling the Great Moderation 2.0. However, the recent further collapse in volatility is also explained by a feedback loop fueled by low conviction, low liquidity, low yields and low fear. Central bank policy has been the largest explanatory factor of both the fundamentals and technicals... and that has BofAML concerned about the risks of short-term volatility spikes exacerbated by market illiquidity.

Look for a speech on Friday August 22^nd by Janet Yellen where she officially signals financial markets that they better start finding their respective chairs.

After several months of quite complacency, investors were woken up Thursday by a sharp sell off driven by concerns over potential rising inflationary pressures, rising credit default risk and weak undertones to the economic data flows. One of the primary threats that has been readily dismissed by most analysts is the impact from rising interest rates...

The market has been so overbought for so long, that most investors were ignoring the clear warning signs that we were in trouble.

We have been warning for a while that not only is the high-yield credit market sending a warning but that it is critical for equity investors to comprehend why this is such bad news. This week has seen exuberant equity markets start to catch down to high-yield's warning but today's surge in HY credit spreads to six month wides is a rude awakening. Between outflows, a huge wall of maturities (and no Fed liquidity), and corporate leverage, the reach-for-yield just became an up-in-quality scramble. HY spreads are over 70bps wider than cycle tights implying the S&P 500 should be around 1775. When the easy-money-funded buyback party ends, will you still be dancing?

As every 'real' corporate bond manager knows (as opposed to playing one on television), forecasting from historical defaults is a fool's errand as the process is entirely cyclical and non-stationary. The fact that default rates have been low for 4 years (thanks to an overwhelming flood of liquidity-driven demand for yield) is of absolutely no use when pricing discounted cashflows into the future. However, as Fitch warns, a jump in US high-yield default rates looms. There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. While most sectors remain relatively clam, the utilities and chemicals sectors are seeing huge spikes in defaults... which explains why the market is starting to price that in.

Something doesn't add up...

Treasury yields are surging across the complex with the long-end steepening notably. Today's 10.5bps jump in 10Y yields is the biggest percentage shift since early November 2013... and a significant tail in the 7Y auction just made things worse.

High yield bond markets are another victim of the "new normal"

We discussed the major rotation, overvaluation, and underperformance of high-yield credit markets recently as relevering stock-buying-back firms find their source of funding starting to dry up. The question is - why now? Perhaps this chart of the wall of maturing corporate debt ($3.9 trillion by 2019 which will need massive liquidity to roll-over and will eat earnings thanks to higher coupons) is what triggered the anxiety as the end of QE and start of rate-hikes looms close...

Despite an early dump on dismal data, US equity markets (except Trannies) 'v-shape-recovery'ed back up to unchanged or better (as Europe closed and POMO ended) on the heels of an increasingly more beta-sensitive AUDJPY rampfest. Trannies never really recovered (3rd down day in a row) and Russell was less exuberant in its dead-cat-bounce but the Dow and S&P closed very modestly green. High-yield credit markets continue to widen - now at 10-week wides (up 35bps from tights) - notably divergent from stocks. Away from the shenanigans in stocks, the USD ended unchanged; Treasury yields were up 1-2bps; and gold closed very modestly lower. Oil slipped 0.5% to $101.60. VIX closed unch. Only the Nasdaq is green post MH17 Headlines on 7/17 and The Russell 2000 is -1.9% and Homebuilders -9% year-to-date.

Yesterday, in what was probably a case of moronic drivel penner's remorse, the same firm which just upgraded its S&P price target by 150 points two weeks ago, decided to... downgrade stocks. But only kinda, sorta and only for the next 3 months: Kostin is unwilling to go so far as to tell the whole truth so while he did downgrade stocks to Neutral through October, he is still Overweight equities over the next 12 months. In other words, sell in July but don't go away, and keep on buying over the next 12 months, or something. To wit: "We downgrade to neutral over 3 months as a sell-off in bonds could lead to a temporary sell-off in equities. This makes the near-term risk/ reward less attractive despite our strong conviction that equities are the best positioned asset class over 12 months, where we remain overweight."

As we have been highlighting for a few weeks, something is rotten in high-yield credit markets. This week, the mainstream media is starting to catch on as major divergences in performance (high-yield bond spreads are 30-40bps off their cycle tights from just prior to MH17 even as stocks rally to new record highs) and technicals weaken. However, as BofA warns, flows follow returns and this week saw the biggest outflows from high-yield funds in more than a year. Investment grade bonds saw notable inflows as investors chose up-in-quality, rather than reach-for-yield, for the first time in years... equity investors, pay attention.

Following yesterday's disappointing results by Visa, which is the largest DJIA component accounting for 8% of the index and which dropped nearly 3%, while AMZN's 10% tumble has weighed heavily on NASDAQ futures, it has been up to the USDJPY to push US equity futures from dropping further, which it has done admirably so far with the tried and true levitation pump taking place just as Europe opened. One thing to keep in mind: yesterday the CME quietly hiked ES and NQ margins by 6% and 11% respectively. A modest warning shot across the bow of what may be coming down the line?