Having exposed the many dominoes that are falling behind the high yield bond market previously, BofA's high yield strategy team are fearful that significant weakness in Emerging Market assets adds one more reason to remain cautious in markets.
If this was not enough to make credit market participants nervous...
Then BofA's Oleg Melentyev and Neha Khoda point out that last week it was Italy; earlier this week it was Turkey; now it is Brazil.
This week alone, the 2yr yields have gone up by 110bps in Turkey and 120bps in Brazil. This move was a culmination of a process that was accelerating over the past few months: the average EM sovereign local currency yield has gone up by 190bps since early May and by 255bps since late February.
We think a sharp 10bps intraday move lower in 10yr yields on Thursday is indicative of this environment.
Critically, BofA's analysts point out:
Rates are falling victim of their own success, where the further they go up the more vulnerability in risk assets they expose, leading to a negative change in risk sentiment and their own eventual reversal.
So far, the market treats these episodes as isolated and unrelated events and yet new problems are now popping up faster than the old ones being resolved.
In other words - the dominoes are falling.
And, as BofA concludes, if EM assets remain under pressure, it may be only a question of time before HY takes a hit, not for any particular fundamental reason, but simply by nature of their historical association. We think the HY market remains vulnerable over the near-term horizon to risk repricing in EM and EU, and as such we are further tilting our positioning towards a tactical underweight here.
What offsets some of this sentiment-driven overhang is the HY technical, which remains very strong. The market has generated close to $4bn in cash so far this week against only $1.3bn in new issuance. Next week, our data shows $3.5bn in coupons and $5.8bn in calls and tenders. The last time we saw a week of issuance exceeding $9bn was three months ago.
However, it is our sense that extreme risk sentiment changes could still overwhelm slow-moving technicals over short term time horizons.