When we first brought the market's attention to high-yield credit's flashing red warning [7], it was shrugged off as unimportant by most - stocks are rallying so who cares (even though we explained in detail why equity investors should care [8]). Now that the mainstream media has all become high-yield bond experts we thought it worth considering how much worse this could get. As Barclays notes, for those keeping track, retail funds have thus far seen 22 consecutive days of redemptions for a total of $16.9bn in assets - the longest streak in history and while the effect of retail selling on valuations has not been negligible, it has also not been proportionate to the magnitude of the outflows (yet).
[9]
In other words - the 2-3% drop in index prices is well short of the 6-7% drop one would expect from the outflows which suggests if selling pressure persists managers will be forced to sell their more illiquid bonds (having unwound the liquid winners) into a market that is as illiquid as it has ever been (for sellers).
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As we noted previously, you were warned:
High-Yield Bonds "Extremely Overvalued" For Longest Period Ever [10]
High Yield Credit Market Flashing Red As Outflows Surge [8]
Is This The Chart That Has High-Yield Investors Running For The Hills? [8]
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But something changed recently...
Between a sudden shift to a preference for "strong" balance sheet companies over "weak" balance sheet companies (the end of the dash for trash trade), and this rotation from high-yield to investment-grade, it is clear that investors are positioning defensively up-in-quality ending the constant reach-for-yield trade of the last 5 years.
Why should 'equity' investors care? The last few years' gains in stocks have been thanks massively to record amounts of buybacks (juicing EPS and also providing a non-economic bid to the market no matter what happens). This financial engineering - for even the worst of the worst credit - has been enabled by massive inflows into high-yield and leveraged loan funds, lowering funding costs and allowing CFOs to destroy/releverage their firms all in the goal of raising the share price.
Simply put - equity prices cannot rally for long without the support of high-yield credit markets - never have, never will - as they are both 'arbitrageable' bets on the same capital structure. There can be a divergence at the end of a cycle as managers get over their skis with leverage and the high yield credit market decides it has had enough risk-taking... but it only ends with equity and credit weakening together. That is the credit cycle... it cycles.
Simply put, Jeff Gundlach was right. [11]
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Of course we have explained this won't end well... [12]
US corporates saw profit growth slow to almost zero last year and on an EBIT basis it has been flat for some time now. Earnings quality, rather than improving is actually deteriorating, as indicated by the increasing gap between official and pro-forma EPS numbers. As a consequence, following a long period of overspending and in the absence of a strong pick-up in demand, corporates will have to spend less and not more.
Finally, as a consequence of such anemic growth, corporates have been gearing up their balance sheets in an effort to sustain EPS momentum via the continuing use of share buybacks. With markets up substantially in 2013 executing those share buybacks has become increasingly expensive. Little wonder companies have to borrow so much to continue executing them.
