Guest Post: Time To Cut High Yield Exposure - Again

From Peter Tchir of TF Market Advisors

Time to Cut High Yield Exposure - Again

Back on June 3rd I came out bearish high yield with a recommendation to short HYG or JNK or to buy SJB  That was based on several factors I was seeing in the market at the time:

1)  CDX indices were trading very cheap to intrinsic value
2)  slightly old new issues were struggling
3)  other markets, CMBX in particular, but European credit as well were extremely weak and were starting to leak into corporate credit market.

Since then I had become more neutral on the market as it had a significant decline (HYG went from 91.30 on June 1 to 87.88 last Thursday).  CMBX had stabilized, We were near the 200 day moving average on SPY and a lot of other risk assets and there was another obvious attempt to figure out a Greek solution. 

I am back to being bearish the high yield market.  I am not yet short it, but would certainly recommend being underweight right now.

A couple of things have pushed me back to being bearish.  The main one is weakness in other credit markets.  Once again CMBX is heading lower and back at or near its recent lows.  It has not been able to sustain a big rally which is particularly surprising because it is relatively illiquid and is a 'hedge' trade so is usually very exposed to a violent short squeeze.  Irish and Portuguese 10 year bond hit new record yields according to Bloomberg - 11.47% and 10.99% respectively at the time of the writing, though Portugal broke 11% earlier in the day.

I have argued that 'solving' Greece does not stop the potential contagion, just that it wouldn't be the first domino.  The realized losses on Greek bonds in the event of a default or restructuring with principal write-downs would hurt other banks and put pressure on the entire system.  That seems like it might be avoided for a while longer (though whether longer is a week or a year is anyone's guess).  What hasn't changed is the problems Ireland and Portugal and other over indebted countries face.  The contagion risk is still there, it just seems more likely that it will be triggered by another country, or else the EU will have to fight bailout fatigue and save another country, again, soon enough.

The 'fundamentals' of HYG and JNK are also scaring me enough to revert to being bearish.  HYG saw its shares outstanding remain stable for the first time since early June, but JNK saw another small reduction, even after relatively large ones on Thursday and Monday.  If the outflows continue, it will be hard for high yield to maintain current prices, particularly given how illiquid it currently is.  And how can you tell how illiquid it currently is?  Last Thursday's price move in HYG bears closer scrutiny.

The relative performance of the price of HYG and the NAV of HYG on Thursday and the subsequent price action is a clear warning sign that liquidity has broken down in high yield.  Last Thursday, HYG dropped almost 2%, and the NAV, which the ETF was already trading slightly cheap to, dropped only about 1/2%.  That is a sign of lack of the liquidity in the market.  Trading volumes dropped and bid/offers widened forcing even institutional investors to cut exposure via ETF's and CDS indices rather than selling bonds.  HYG has performed well since that Thursday - as have almost all other 'risk' assets.  What concerns me is that NAV continued to drift down Friday and Monday.  Clearly investors were waiting to sell some high yield bonds into strength.  I would be more optimistic for a strong bounce if the NAV had not leaked lower for 2 more days.  It did finally go up yesterday, but HY16 finished up almost a point yesterday, so a 1/4 point uptick in NAV on HYG is just not that bullish of a sign.

The combination of weakness in other credit markets, coupled by the HYG NAV confirming that liquidity is at an extreme low in the high yield bond market I think it is prudent to cut high yield risk.  With European credit closing quite weakly, I may shift to an outright short.