Is High Yield Credit Over-Extended?

Tyler Durden's picture

"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.

Chart: Bloomberg

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JW n FL's picture



"Reach for yield"


The firm returned 23% last year—the second-worst for hedge funds on record, when the average fund lost about 5%.

Bridgewater's returns were driven by investments in U.S. and German bonds, as well as on the *Japanese yen, The New York Times reports.

The firm returned about 45% in 2010 after earning modest gains in both 2008—the worst year for performance in hedge fund history—and 2009.

This year, Bridgewater has joined the gold bulls, seeking to hedge against inflation. In the same vein, it is betting against a number of emerging-market currencies and the Australian dollar.


* I like Kyle (Bass) but dont ever bet against Japan.

RobotTrader's picture

Check out the muni-bond ETF's.


All of them are going completely parabolic.

Dominating the list of 52-week highs today.

lolmao500's picture

More wars down the line in the middle-east... if you thought Iran or Pakistan and maybe even Syria were the ``last ones``... think again.

The Egyptian Nuke


Mr Lennon Hendrix's picture

A year ago when asked how important it was to change Egypt's political regeme, Kissinger said, "Egypt is the key."

Yesterday he said, "If you don't hear the drums of war, you are deaf."

Something wicked this way comes.

The Axe's picture

not if the fed has your is off and running

Captain Kink's picture

What's not priced in is $1,000,000,000,000 in mortgage purchases.  Over perhaps 1 year. And we know from looking at hyperinflationary episodes in the past that the equity markets explode higher before the endgame ensues.  It is not about inflation yet though, but rather the change in the rate of growth of the money supply (It is really the second derivative that matters most here.). Hyperinflation is a long way off. 

China has been curbing the growth rate (if not outright reducing its organic money supply) over the recent past and "succeeded" in reducing inflation (if you believe their numbers) from 6.5% to 4.6%.  They are now re-ramping growth.  As is Brazil.  And Europe (post Trichet), which just added 1/2 Trillion Euros to the banking system, whether or not you believe it is in their economy yet.  And Japan?  Just entered deflation...what news do you expect from them? The fact is that the spigot is on full fire hose blast from every corner of the world, and there is no way that a lot (if not at least some) of that money reaches the US market as the only wearable shirt (for now) in the hamper.  Add to this the FACT that QE3 of $1 T in mortgage purchases is on the way.  The Fed has us conditioned now to expect that QE means higher markets--equity and commodity--so the reaction is and will become-- even more EXPLOSIVE. 

The Fed gave us the Jackson Hole speech already.  The new inflation and (soft) unemployment targets will demand that they act.  It is out of their hands...inflation, (as they measure it) is too low...and at the same time, unemployment is too high.  This is the genius of the targets regime. QE3 is a foregone conclusion, and it will be HUGE.  QE2 was the test run, and the Bernank was practically gloating when he asserted that the commodity price effects were"transitory" as evidenced by the price behavior in the markets.  They did the 600 billion test, now they have license to print $1T every time the "inflation" rate drops below 1.5%   Bank on it.  And buy silver and gold, Mortgages, and Equities...and the Russell.


jimmyjames's picture

The fact is that the spigot is on full fire hose blast from every corner of the world, and there is no way that a lot (if not at least some) of that money reaches the US market as the only wearable shirt (for now) in the hamper


I wouldn't doubt that happens-especially if that foreign money gets nervous about local markets and with bond yields crashing-it very well could end up in US markets-if it does and markets rock-what excuse will Ben have to hit the money guns-

hyper-critical's picture

Pretty much spot on. Potential pullback imminenet, but then again, everybdy's looking for it so it may not materialize.

Mr Lennon Hendrix's picture

More like reach around for yield.

Rainman's picture

Eggsacly ! The public pension funds must be balls out in this space for yield. Those 7.75 assumptions are hounds snapping at their asses.

PontifexMaximus's picture

More war rumours! Better for the markets!

Money never sleeps's picture

Holy Batman, this Armada Markets rocks!

ilion's picture

Pretty nice site they have! I guess exchange traded FX will be the new standard! Go Armada!

jm's picture

We may be seeing some of those vintage loans/bonds relative value posts coming back.

covert's picture

there isn't enough safety in the lending market.


UP4Liberty's picture

Need you ask?

Is the question even necessary?

Money never sleeps's picture

Armada Markets just tweeted this stuff: Priceless indeed.

Yen Cross's picture

 OXYMORON!   Enough said?

jaffa's picture

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