Putting It All Together: When Does The Junk Bond Sell Off End, And When Should One Buy

Tyler Durden's picture

UBS' chief global credit strategist Matthew Mish has been on a roll lately. After first revealing "how the investment grade dominos will fall" in mid January (an analysis which was followed by another leg lower in IG bond prices), and then two weeks later instead of focusing on products, Mish analyzed sectors and explained "What's The Next 'Energy' Sector In Credit Markets", today he tries to put it all together and as he himself puts it, "the inquiries we have received are increasingly from investors across all asset classes and regions, and lines of questioning evolve in many directions. But the genesis of the debate comes down to three questions: first, why is the sell-off happening; second, when does it end; and third, what can slow or speed up the process?"

We are certain that these are the questions asked by every single credit investor, so without further ado, here are Mish's answers.

What is the clearing level for $1tn in stressed credit?

First, why are HY credit markets wilting? For non-credit investors the simple analogy is a balloon. The air going into the balloon was essentially inflows into credit funds. Our prior work suggests inflows have been driven by three factors: quantitative easing, credit losses and past performance. From 2010-2014 the environment was extraordinary; at its peak, the Fed was buying roughly $1tn annually in fixed income securities, crowding investors into corporate credit; defaults were low as capital markets were accessible and earnings were expanding, and prior HY returns were unprecedented. The money poured in, and credit funds put that cash to work. However, that mirage has faded; the Fed is tightening policy, defaults are rising due to commodity price declines and excessive leverage, and past performance has been negative. Outflows are triggering forced selling across real money and hedge funds.

However, the problem is not simply technical. The root cause is fundamental in nature. During that period of euphoria, credit portfolio managers were essentially forced to buy the market. The inflows were too robust. In that environment, fundamental credit analysis became secondary. Clients had yield targets to achieve, and with central banks pushing interest rates towards zero those that bought high grade credit in prior decades bought high yield; those who purchased high yield previously bought triple Cs. Unfortunately, investors were being compensated in a fairly linear fashion across IG, HY and CCCs. Later in this period a few hundred basis points was the yield differential between IG versus HY and HY versus CCCs (Figure 1). But realized defaults increase at an exponential rate when one moves from IG (Aa, A, Baa) to HY (Ba, B, Caa, Figure 2).

* * *

Second, when does the credit sell-off end? Unfortunately, we believe the answer to this question is complicated – complicated in that traditional models may not provide a perfect guide. Models always work better in than out-ofsample, but model risks increase when there is a structural or paradigm shift. In the current environment, there are at least two possibilities. First, the level of dispersion in US high yield between commodity and non-commodity industries is quite extreme by historical standards. Second, the lower quality segment of the high yield (and all leveraged credit markets) is undergoing a structural shift in that the proverbial balloon is no longer inflating, but deflating. Capital is wounded and illiquidity is complicating an exit as the saying goes 'fool me once, shame on you; fool me twice, shame on me'. A new marginal buyer is needed. And the overwhelming majority of potential new buyers we speak with are fundamentally pricing lower quality risk through the cycle (or restructuring process) and under the assumption this debt is illiquid.

In our 2016 US high yield outlook we posited there is one central question that will dictate the outlook for high yield: will credit markets be able to absorb refinancing needs of almost $1tn stressed and distressed credit. And we continue to believe this should be THE debate in the market. In our view, if the lower quality rung of the market cannot stabilize the balance of risks is for contagion to spread further. So what is the clearing level for what we believe is upwards of $750 - 1tn in stressed credit? First, investors will require compensation for loss risks; cohorts of triple Cs typically experience 5yr cumulative default rates of 55 - 65% near the end of the cycle, implying half of the universe defaults before the end of year 5 and no longer pay coupons. Assuming recovery rates of 35% an investor should require roughly 12% yield to compensate for loss risks alone. What about mark-to-market and liquidity risks? While triple C bonds are trading on average in the low $60s, investors will likely need to stomach a further decline later in the cycle. Historically, triple C prices bottomed in the $40 – 50 range, so potential MTM declines could be significant (Figure 3).

Further, although our prior analysis assumes hold-to-maturity, investors will need to be compensated for the fact that illiquidity may prevent them from selling when needed. Bottom line, our conversations with investors suggest yields in the 20 – 25% context could be attractive enough to draw in marginal capital – although several investors noted that is reasonable for triple C risk excluding commodities. In short, we're not there yet.

* * *

Third, what reverses or speeds up the process? We would reiterate the primary drivers of fund flows are credit fundamentals and central bank policy. Higher commodity prices would ease, albeit not remove, default concerns. Better-than-expected earnings could also help sustain excess leverage on corporate balance sheets. And aggressive monetary policy – that which could conceivably push investors back into lower rated credit – could extend the cycle. And the reverse is also true in both cases.

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Soul Glow's picture

When will I buy junk bonds?  When the Dow Jones is  at 5k.  Then I'll come back into the markets.  Until then it's cash and bullion and shorts.

TideFighter's picture

Yup. S&P <666, I buy. Otherwise, I keep my canoe waxed and fast.

uhb's picture

but then, at 5k, you can also go long the company stock...

chubbar's picture

OOH OOH, I think I may know this one! When the company underwriting the bonds goes BK and the junk bond goes to zero?

Bank_sters's picture

Never.   Now on to the next question, will the ppt get the market to close green today?

Kefeer's picture

Friday buy-up is a must..or not.

Bill of Rights's picture

When the SPY is 166....

offwirenews's picture

Already talking about when to get back into junk? Are you f****** me?


Which makes me wonder why the hell Gundlach said something like if vix is above 40, it may be time to start thinking the bottom is in for hy bonds? What?!

scraping_by's picture

Back when investing was an adult activity, HY bonds were seen as the equivalent of making a World Series bet in March. Then came Millican and the PR went up while the IQ went down. If and when the gunslingers have lost enough OPM, it will once again be somewhere to toss a few dollars you didn't need anyway.

Orc from Mordor's picture

Invest in graveyards, yankees. You'll soon be short on them.

Kefeer's picture

Unless you are Russian; we have more land...or Canada.  Either way; you will be in a grave one day...never forget that.

mrdenis's picture

The fifth friday of the month ....

buzzsaw99's picture

so it's a ponzi scheme, just like stocks. it's all about the flow while fundamentals have little to do with anything? yeah, i already knew that, i read zh.

aardvarkk's picture

I don't read ZH.  I just come here for the pictures.

taketheredpill's picture

Compare 2016 to 2008....



Much less investor protection since in 2014 over 60% of debt issued was “Cov-Lite.  In 2007 the previous peak was 25%.


A lot of the borrowed funds have gone to Share buybacks rather than Capex.  Since there will be less hard assets left over when Bond holders end up owning the firm,  the recovery rates on liquidation pricing will fall.


In 2008 you could look at previous 5 years of growth and assume the US economy will recover to a 4% GDP growth rate, and factor that into how much you’re willing to pay for the firm (based on asset value and expected profitability). In 2016, who is predicting growth to reach 4%?


Regulatory changes design to make US banks safer have restricted how much corporate bond inventory they can hold on their books.  There is no “buyer of last resort”.



There's a 5th one but I can't remember it.  In any case, the cycle reverses and the feedback loops go into reverse (and faster since fear trumps greed) and unless a spaceship arrives desperate for workers on another planet...HY is fucked.


"credit portfolio managers were essentially forced to buy the market"

No shit, and not just credit portfolio managers.  I had a gun put to my head and had to go to 15% HY.  After maturities and Refis I'm at 3% but still freaking out.


gatorengineer's picture

Kudos for the Fed and its minions at Citadel for doing such a stellar job at keeping this market from completely collapsing.  Cant believe that we haven had that 5 plus percent down capitualtion day (yet).  Cant believe that some hedgies or commodity firms havent blown (yet). 

ghengiskhan's picture

We have another Gorilla hiding in the room that no one is talking about.  The publicly traded companies living off of Junk couldn't lay people off even when they needed to because then you show your real hand (and trigger audits) and when you are in this deep you are all in.  So what we have now is a huge range of companies right on the edge of the cliff that will end up laying off 50% of their employees overnight.

johmack2's picture

i still dont think this is the big one, we will have come capitulation but on and upward because of nirp. Obama needs a good amount of distance away from the mesh before it goes tits up. The big one happens when companies are dragged kicking and screaming to raise interest rates. We still have more QE,NIRP,DIRECT MONEY DEPOSITS INTO BANK ACCOUNTS via CENTRAL BANKS and BAIL INS,  to go. If a large degree of people are expecting it...it wont happen. Only a handful of commenters caught the 2008 recession, 1980s recession, the great depression etc, Now we have every newspaper talking about this for months on end. You cant crash if your driving fast and your eyes are focused on the road ahead. NIRP will FORCE a flood of cash into assets then once everyone is drunk then will it crash for good




Kefeer's picture

So if the Russians, OPEC and non-OPEC nations were to intentionally cut production to drive up oil, which would likely bring other commodities with it; the credit risks would be re-inflated to a point...then in 3-4 months, the same group re-floods the market and drops the oil quickly down from say $50-$60, then back to $25 after jawboning before the glut/flooding that they expect price to go to $70 by end of 2016.


That should kill off many of the parasites plaguing all of us.  I hope Putin views ZH comments.

cornflakesdisease's picture

Answer to the headlines question?



medium giraffe's picture

ECB JunkenBomb


Mamma mia!