High Yield Bond Shorts Hit Record Highs Amid IG Credit's Worst Year Since Lehman

2018 is looking like being the worst year for investment grade credit markets since 2008's Lehman-led collapse...

And worse still, Citigroup's analysts are weary that the clock is ticking for the riskiest corporate bonds...

“The markets are entering a new phase of increased volatility,” they wrote, and “we are a long way from a sustained high yield recovery.

Prices for bonds rated CCC or lower (the weakest high yield credits) have dropped about 8.7% since the credit selloff started in early October, according to Bank of America Merrill Lynch Indexes. And as prices fall, yields on CCC-rated bonds have climbed to 11.5%  - well above the current coupon around 8.1% (meaning dramatically higher refunding costs).

As about 34% of CCC-rated bonds come due in the next four years, up from 20% in 2010, according to Citigroup, Barrons notes that these companies will need to decide whether to pay down debt or refinance at higher rates. Either way, they will need to focus on cash.

All of which perhaps explains why, as The Wall Street Journal reports, bond investors scrambling to protect themselves from losses are increasingly using bets against the largest junk-bond ETFs.

The value of bearish bets on shares of the two largest junk-bond ETFs hit a record $10 billion in recent weeks, according to data from IHS Markit . 

A record 59% of shares outstanding of the largest junk-bond ETF have been sold short, up from about 35% in September, according to data from S&P Global Market Intelligence.

WSJ reports that appetite to short the ETF, operated by iShares, has far exceeded the number of shares available to borrow; ETF brokers have created an estimated $2 billion new shares to meet the demand since the start of October, said IHS Markit analyst Samuel Pierson. Short sellers of stocks and bonds are constrained by the amount of securities they can borrow. But ETF brokers can create new shares specifically to lend them out, allowing for much larger bearish positions.

Additionally, negative bets (or hedges) on indexes of credit default swaps, or CDS, for junk bonds hit a four-year high in November, according to Citigroup .

“There’s been increased interest because people are concerned about the credit market as we get closer to the late stages of the credit cycle,” said Calvin Vinitwatanakhun, a Citigroup credit-derivatives analyst.

And, as we recently detailed, Morgan Stanley strategists now expect this bearish turn in credit to continue in 2019.

The tricky handoff from quantitative easing (QE) to quantitative tightening (QT) that is under way is central to the cracks that have appeared across risk markets and credit markets in particular. Global QE provided the necessary conditions for corporations to lever up, which is exactly how they responded.

Outstanding US corporate credit market debt has more than doubled from US$3.2 trillion in 2008 to well over US$7 trillion today, with the biggest chunk of it coming in the BBB portion of the credit curve, the lowest rung of investment grade ratings. High debt growth has translated to high leverage – BBBs with 31% of BBB debt leveraged at or above 4.0x.

Lower yields driven by QE had important consequences for investor behaviour as well. The search for yield became a driving force which led to substantial inflows into US credit, particularly overseas investors. Also thanks to the Fed emerging as a large non-price-sensitive, programmatic investor of agency mortgage-backed securities (MBS) as part of QE, fixed income investors became progressively underweight MBS and overweight corporate credit. As the cycle got extended, the net result of these flows into credit investments has seen the manifestation of late-cycle excesses in credit markets. High debt growth has led to high leverage and weak structural protections for credit investors.

With the transition into QT, these flows are reversing. We have a marked drop-off in 2018 of foreign investor flows into US credit investments.

And equity market participants should be worried.

Credit markets have led the tightening liquidity downswing in markets.