Is High Yield Credit Over-Extended?
"Reach for yield" is a phrase that never gets old, does it? Whether it's the "why hold Treasuries when a stock has a great dividend?" or "if this bond yields 3% then why not grab the 7% yield bond - it's a bond, right?" argument, we constantly struggle with the 100% focus on return (yield not capital appreciation) and almost complete lack of comprehension of risk - loss of capital (or why the yield/risk premium is high). Arguing over high-yield valuations is at once a focus on idiosyncrasies (covenants, cash-flow, etc.), and technicals (flow-based demand and supply), as well as systemic and macro cycles, which play an increasingly critical part. Up until very recently, high yield bonds (based on our framework) offered considerably more upside (if you had a bullish bias) than stocks and indeed they outperformed (with HYG - the high-yield bond ETF - apparently soaking up more and more of that demand and outperformance as its shares outstanding surged). With stocks and high-yield credit now 'close' to each other in value, we note Barclay's excellent note today on both the seasonals (December/January are always big months for high yield excess return) and the low-rate, low-yield implications (negative convexity challenges) the asset-class faces going forward. The high-beta (asymmetric) nature of high-yield credit to systemic macro shocks, combined with the seasonality-downdraft and callability-drag suggests if you need to reach for yield then there will better entry points later in the year (for the surviving credits).
Compare the flow of shares outstanding (black line) as increasing demand for yield drove investors into the high-yield ETF. However, unlike what one might expect (demand-based price action), prices have not risen significantly in the last few months (as demand for creation of shares has blown up). The rally in HYG over the last week or two is notable though as the December/January seasonals come into play.
The seasonals in high-yield credit are astounding as Barclays points out and with so many now watching credit markets for signs of stress, the seasonal front-running and implicit flow has likely reflexively led and confirmed the risk-on rally. That seasonal strength is about to end.
With interest rates so low, and spreads compressing, high-yield bond all-in yields have compressed significantly leaving more than 30% of Barclays HY Index trading above their next Call Price. This means that high yield credit is increasingly prone to negative convexity concerns. In English this means that as yields fall (and prices rise) on high yield bonds (which often have a call option embedded to enable the borrower to repurchase the debt - and perhaps refi at the new lower rate), then it becomes increasingly likely that the firm would exercise the call and buy back the debt. This impact is called negative convexity as it causes the price of the bond to stabilize instead of following up the 'normal' convexity curve (so will underperform).
The point is that the higher the price of high-yield bonds get, the more of a negative impact of this callability and the less attractive the bonds become. The chart above shows that we are already above the levels of the peak in 2007 and are rapidly heading to the peaks in 2011 especially as the Fed flattens the curve out to 5-7Y (where most HY debt is maturing before this).
If the demand for HYG shares could not pump up prices, and seasonals are abating, and negative convexity concerns are increasing, and relative valuation with stocks is not compelling, perhaps the asymmetric nature of high-yield bond returns will be too much for even the 'reachers' to bear as we face a series of known and unknown unknowns in the coming months that will more than less impact credit markets (liquidity and all) first.