May 23, 2014
By Steve Blumenthal
“Once in a while you will stumble upon the truth but most of us manage to pick ourselves up and hurry along as if nothing had happened.” – Winston Churchill
Trading high yield bonds for nearly 24 years has taught me a thing or two about opportunity and risk. Today, I share my current thoughts on high yield. In short, I feel good, really good and, frankly, that is what is troubling me. The last several times I felt this way a major sell-off followed. Be prepared and properly position for an outstanding once in a decade opportunity. It is coming.
Remember these words, “currently vulnerable to non-payment”. The first market to turn down will likely be the high yield market (historically a leading indicator of equity market behavior). So let’s dig in to what is going on beneath the surface in high yield and talk about what you can do to be positioned to profit. Also, I’m really excited to share with you that I published my first article in Forbes today (link provided below – please let me know what you think).
“Stumble upon the truth and act?” It sounds behaviorally reminiscent of bubbles past; or does one “hurry along as if nothing has happened?” Clearly, it is best to act.
Let’s take a look at the following in this week’s On My Radar:
- High Yield Bonds Go From Way Overvalued to Way, Way Overvalued
- Currently Vulnerable to Non-Payment
- How Not To Get Soaked When The Bond Bubble Bursts – Forbes
- Trade Signals – Interest Rate Risk
High Yield Bonds Go from Way Overvalued to Way, Way Overvalued
“Monetary policy is the key to the present, extended period of overvaluation. The Fed’s explicit objective is to push investors into risky assets by artificially depressing interest rates. In response, investors are accepting excessively small compensation for credit risk, so desperate are they to boost their yields. High yield portfolio managers are not unaware of the inadequacy of spreads, but are willing to skate on thin ice on the assumption that the Fed is committed to rescuing them if anything goes wrong.” – Martin Fridson
- High yield has now been extremely overvalued for seven consecutive months, the longest streak in history. (Option-adjusted spreads are available from Dec. 31, 1996 onward.)
- Moreover, the actual spread has been less than fair value (although not always at an extreme) for 23 consecutive months (see the chart below). That is not a record, but it is ominous that the longest such streak on record, 27 months, came to an end in September 2008, the month in which Lehman Brothers collapsed, plunging global financial markets into chaos.
- Marty’s fair value estimate on the yield difference is 570 bps. In English this means that if safer Treasury notes of similar maturity are yielding 2.50%, then the fair yield on high yield bonds should be 8.20% (2.50% + 5.70%). Once should get paid more for investing in riskier bonds. He references the BofA Merrill Lynch U.S. High Yield Index (formerly known as the High Yield Master II).
- Here is the problem today: The actual spread, as of April 30, 2014, was 371 bps. This means the current yield an investor should be paid for taking on the risk of investing in riskier companies is nearly 2% less than it should be, or as measured in extremes, this is -1.53 standard deviations away from the normal trend. We don’t often see such mispricing.
- It is the chase for yield has driven high yield bond prices to excessive levels. They as richly priced. Note the other periods of extreme overvaluation in the following chart (yellow circles):
Currently Vulnerable to Non-Payment
Picture the following: As investors race to find yield, more and more money flows into high yield bond mutual funds and ETFs. Those fund managers find themselves with extra cash to put to work. Their mandate is to invest in the space so the money is put to work (immediately or close to immediate as possible in the ETFs).
At the same time, corporations have been less willing to borrow – issue new bonds (excluding rolling over existing debt or refinancing existing debt). The result is more buyers than sellers. There is more money to be put to work then there are available bonds to buy. Prices are bid higher and lesser quality companies find a way to raise money. Worse yet is that such bonds are issued with what is called lite covenants; meaning there is less backing your bond if the company defaults. You, the bondholder, are even more vulnerable to a non-payment. Such bonds are hit even harder in the next cycle correction.
While prices are remaining firm today and all looks good on your most recent account statement(s), the underlying fundamentals are weakening. This next chart shows weakening trend in quality of bonds.
Here is a little more data on high yield:
- The full-year reading now shows inflows of $4.9 billion and it’s roughly 12% related to the ETF segment. In contrast, one year ago at this time, the inflow total stood at approximately $2.5 billion, with a breakdown of $2.7 billion of mutual fund inflows and $204 million of ETF outflows.
- It took three decades for the amount of speculative-grade debt to reach $1 trillion. It took about seven years to reach $2 trillion as investors sought relief from the financial repression brought on by near-zero interest rates. 30 years vs. 7 years. Amazing.
- The market for dollar-denominated junk-rated debt has expanded more than eightfold since the end of 1997 from $243 billion, according to Morgan Stanley. That compares with a quadrupling of the investment-grade market to $4.2 trillion as tracked by the BofA Merrill Lynch U.S. Corporate Index.
- An example of what we are seeing: Michaels, based in Irving, Texas, in undoing about four years of debt reduction issued $800 million of 7.5 percent notes due in five years to pay a dividend to its private equity owners, Bloomberg data showed. The debt was ranked Caa1 at Moody’s and CCC+ by S&P, ratings that indicate very high credit risk that’s currently vulnerable to non-payment. (emphasis mine)
Finally, I believe more investors will be tested the next time the market gets rocky. That’s because high yield ETFs are becoming a greater presence in the high yield bond space. Late last year, around 10% of daily trading in high yield bonds was owed to ETFs, according to figures released by BlackRock (BLK). That was just about the highest level of any point in the last three years. The comparable figure was as low as 2% in late 2009. I believe that number is even higher today.
Remember late May 2013 (Taper Tantrum)? Then the high yield market and fixed income markets in general were shocked by Bernanke’s mention of QE exit. ETF HY volume on May 31 was more than 35% of the underlying market’s $4.7 billion in value traded, according to the BlackRock figures.
The high yield market is nearly $2 trillion in size. According to our research, there is roughly $294 billion in high yield mutual funds (source: Morningstar Direct High Yield Bond Category) and roughly $47 billion in high yield related ETFs (from Cantor Fitzgerald ETF trading group). A big bump up in ETF assets.
It used to be the large bank trading desks that provided liquidity and daily price discovery. Most of those desks are downsized or gone and few firms allocate capital to in-house inventory. The market making function of old has shifted. The ETFs are now the source of price discovery and instant liquidity.
Facing daily redemptions, the ETFs will be forced to sell. The question then becomes: who is going to step up to make a market? Yet to be tested.
What you can do: A better approach, I believe, is to tactically trade your high yield bond exposure using funds or ETFs. I’ve been doing it for 20 plus years. It is not hard but it takes strong discipline and a traders DNA. I am really looking forward to the next crisis and the opportunity it will create. I believe it may just be the best set up in more than 20 years. Note: past performance does not guarantee future success.
How Not To Get Soaked When The Bond Bubble Bursts – Forbes
Trade Signals – Interest Rate Risk
A look at the most recent investor sentiment and market trend charts. Sentiment is nearing extreme optimism again and both the equity market and fixed income cyclical trends, while aged, remain bullish.
Click here for a link to Wednesday’s Trade Signals.
“Stumble across the truth” may be one thing. Taking action is another. I believe we are near an inflection point (my best guess is mid-2015 when the Fed is projected to raise rates). Just what trips the next avalanche of selling and when no one truly knows. What is known is that there will be little time to act if standing below the break.
Fundamental ratios like price/earnings, price/book, price/sales, cyclically-adjusted price/earnings, price/cash flow, etc. really do matter. When the typical bull market that lasts less than 4 ½ years is soon pushing 5 ½, it may be time to prepare. When the historic 50-year median S&P 500 PE ratio is 16 and it is now above 21 with profit margins at record level, you have to question if you are buying value.
I speak with and/or read monthly research letters from several of the greatest hedge fund managers in the business. My team interviews hundreds of managers and thought leaders each year. I have yet to find the gifted manager who can consistently time a top or bottom.
In my early years, I naively searched for a magic indicator. No such luck; however, what I believe we can do is identify high periods of risk, stay aligned with the major trend and identify period of greater and lesser risks. We can also get prepared and position (at little cost) for a coming storm. Taking advantage of opportunity is impossible with a portfolio in crisis down 30% to 50%.
For now, don’t fight the tape nor the Fed appears to hold footing but it is good to remember that this cyclical bull move is aged, margin debt is at record high, profit margins are high, valuations are high, interest rates are near record lows, high yield bonds are way too expensive and the Fed is ever closer to a QE exit.
It is that I feel so good today that worries me. Something big is coming. I felt this way in 2007 (Greenspan’s “there is no irrational exuberance” “no bubble in housing”) and 2000 (at the end of the great bull market/tech bubble – the “this time is different” time) and in 1990 (just prior to the Drexel Burnham Michael Milken crisis). It never feels this good when opportunity is greatest (i.e. 2008/09). For now, patience is required. As is a portfolio allocation that allows for gain yet defensively protects.
The regulators tell me that past performance guarantees nothing and they are correct. Logic tells me a creative Fed may become even more creative extending the runway. I can hear my father whisper to me to stay aware – be prepared.
How do you tell your client you exited equities in front of another 20% gain? You can’t. A potentially disastrous business miss as the advisor across the street smiles and takes your client.
Great hedge fund managers like David Tepper, Kyle Bass, George Soros and Stan Drunkenmiller can take such risks. Can one afford to allocate all of his money to just one manager? John Paulson’s fall comes to mind. Hussman’s miss. For your clients and your business, it is best to broadly allocate to a diverse set of risks.
Speaking of Tepper – PJ wrote a nice article on CMG AdvisorCentral called Tepper Tantrum. It is short and very well done.
Fortunately what you can do is tail risk hedge your equity exposure and further expand your portfolio construction to include non-correlating tactical trading strategies as well as several other alternative sources of return (managed futures and long/short funds come to mind).
Consider today a shift from 30% equity (hedged), 30% fixed income (flexible bond exposure) and 40% tactical/alternatives. Underweight equity and fixed income exposure today. There will be an opportunity to overweight again in the near future.
Some golf with the kids is in the weekend plans and of course a cook out or two. Tomorrow some long- time soccer friends are coming over to watch the UEFA Champions League final. Surprisingly, it is between two teams from Madrid. That should add to the emotion of the game.
Have an outstanding weekend, leave the work at work, keep the chore list small and the family and friend list big.
With warm regards,
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
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