Just over a month ago we noted the clear exuberance in the junk bond space in the context of the growing usage of the word “bubble”. At the time, various junk or high yield indices had seen yields fall laughably below or near 5%. It was not all that long ago that short-term US bills and even some money market funds yielded the same nominal rate.
Of course, modern finance is nothing but unconcerned about nominal rates, preferring more close examination of spreads. That is the textbook approach to both trading and the monetary economics that drives monetary policy. The Fed knows bond traders look at spreads which is why they know they can influence credit markets in all segments just by screwing with the treasury curve. Like moths to a flame, spreads are all that translate.
I’m not dismissing spreads as unimportant, but near or at the zero lower bound due to monetary policy we lose something by ignoring nominal yields. Sure, we can construct interest rates like Benjamin Graham as the sum of credit risks, inflation risks and a “risk-free”, but what if the “risk-free” is artificially too low that further leads to an underappreciation for credit risk. After all, nearly every financial model on the planet contains some mathematical relationship between low “risk-free” rates and low estimations of defaults. The Fed’s own academics used this artificial construction in a similar exercise just recently.
If this is the case, then spreads might make sense but nominal yields do not. And decidedly so.
In the vortex of volatility that has engulfed credit markets since the Bank of Japan unleashed record experimentation coupled with FOMC concerns over bubbles manifested in talk of QE taper, the high yield space has taken it on the chin. The move in junk is, as expected given the usual beta, outsized. Beginning May 28, junk spreads decompressed (widened) 73 basis points in only seven trading days. This happened concurrent to the selloff in US treasuries, an occurrence not normally correlated.
Despite the dramatic selloff, there has been very little talk or appreciation of it. Junk bonds are usually a signal to market inflections, or at least structural changes in positioning and appetite.
A friend of mine, Bill D in Boston, passed along another bit of information that shows exactly what I mean. Just this week there have been 10 high yield bond cancellations due to “market conditions”. Of course this could just be a temporary pause in an otherwise voracious market, but if it is something building then it spins into a liquidity event first in the lower rung corporate operations. Firms that can’t easily raise money begin to falter and that raises the risk perceptions across the board – particularly credit risk.
Once that happens, spreads are re-evaluated and even more attention to nominal yields as they relate to good ol’ fashioned fundamental concepts like risk/reward – as in are these bonds paying enough if defaults begin to occur at a rate above what the models predicted? Maybe even the near ubiquitous return of “cov-lite” will seep into that calculation as well.
We are still a long way from that, but it will be interesting if “volatility” in junk can be ignored forever. It is an extremely important market that sets the pace of risk appetites nearly across the board, including stocks.
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