State of the High-Yield Market
ETFs and closed-end funds are attracting a lot of attention. Redemptions and poor performance in the past few days have caught a lot of people's attention. It also sounds as if that attention is hitting traditional mutual funds. It is worth looking at.
Unmitigated Disaster in Closed-End Funds
The craziest closed-end fund I know is the PIMCO High Income Fund (PHK) fund, which was down 26% since its peak but still trades at a premium of 27%. I have never understood why people pay such a premium for a fixed-income fund, and never will. To me, it is completely irrelevant what this fund does, except as a sentiment for the least thoughtful retail investors. We saw steep declines in other closed-end funds. Most had been trading at a premium and are back to about intrinsic value. With the leverage they use and small market cap I rarely follow them, but the size of the move is worth looking at.
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Even the leveraged loan closed-end funds got hit hard. They are still at a premium, but seeing drops of 3% to 5%. That is far in excess of the two-day drop of the PowerShares Senior Loan Portfolio ETF (BKLN), which has had a 1% drop. The leverage and premium explain a lot of that additional drop.
Buying fixed income funds at a premium to NAV is an accident waiting to happen. Confusion over taxes of the dividends may not be helping either. It isn't just PHK, there is Western Asset Managed High Income Portfolio (MHY), Eaton Vance Senior Income Trust (EVF), and PIMCO Income Strategy Fund (PFL), to name a few.
Mitigated Disaster in ETFs
I hate having to talk about the "crazy uncle" of fixed-income investing -- closed-end funds -- but the moves were so shocking it is worth at least noticing. The big ETFs held up better, but are sending some disturbing signals.
It looks like iShares iBoxx $ High Yield Corporate Bond ETF (HYG) has had about $500 million in redemptions since the election. I am guessing SPDR Barclays Capital High Yield Bond ETF (JNK) has had about $400 million in redemptions (it looks as if State Street delays reporting shares outstanding longer than Blackrock does).
So I would say we are on pace to see over $1 billion of redemptions from these two funds alone. That is big, but with almost $28 billion of assets between these two ETFs, it isn't a huge portion of their assets -- yet. Since ETFs tend to lead traditional fund flows, we should be seeing significant flows from them as well.
BKLN seems to have the worst reporting for shares outstanding. It seems to be static, then have decent sized moves. If the data can be believed, it looks like inflows since the election and stability this week. That seems reasonable with the price move and general view that loans are a good value here with a decent margin of safety if the economy does worsen. This is about the only bit of encouraging news in the ETF space.
iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has also been OK. It looks like just over $200 million has been redeemed on an asset base of $25 billion. Another sign that this is more isolated to high yield than the closed-end funds would indicate.
For what it's worth, it looks like PIMCO Total Return (BOND), the Pimco actively managed ETF, has attracted money throughout the entire post election period. Is that a vote for active management or the fact that it is positioned in mortgages and treasuries?
iShares Barclays 20+ Year Treasury Bond ETF (TLT) also had big inflows. That is encouraging in that it shows investors are allocating from one segment of fixed income to another, so this isn't just a capitulation out of fixed income. It is discouraging in that it shows the move out of high yield is thoughtful and not random.
HYG is down 1.8% since the election. JNK is down 1.5%. LQD is about unchanged (it's a yield product, not a spread product). BKLN is down 1.2%. Those returns all seem about right in the context of the overall sell-off since the election.
IG19 went for 96.5 to 109. That is about 5/8 of a point in price terms. That is a big move any way you look at it. It went from trading rich to trading cheap. IG18 is back to pre-OMT levels. The IG CDS market moved faster and further than anything we see in the cash side. It looks like there were few hedges and even fewer shorts. It remains under pressure in spite of now being cheap and it can't be because of the arb, because the "cheapness" is small enough that arbs won't really do much with this. Of all the moves, this one seems the most out of place. The ETF moves make some sense. The closed-end fund moves are heinous, but should be.
HY CDS has also done poorly. HY19 is down from 99 7/8 on election eve, to 97 3/8. So down 2.5%. It has done worse than the ETFs, but makes sense. The ETFs have had some benefit from the overall move in yield supporting the price of some higher quality paper, whereas CDS is pure spread. The CDS index tends to have a larger portion of risk tied to sketchy illiquid names. So this move at least makes sense relative to other markets. If the ratio of IG to HY is 4:1, then they moved about in line. I tend to think the ratio is higher, more like 5:1, which would indicate to me that IG is the underperformer again.
Risk-Off, Taxes, or Earnings?
What is driving this? Is it just part of a generic risk off move? With S&P down 5%, credit needs to be cheaper to be attractive? That makes some sense.
Is it because of taxes? That makes no sense to me. People cannot have that much in terms of capital gains in the fixed-income ETFs to be selling for that reason. If dividends are less appealing because the tax changes, then the already fully taxed credit world should look relatively more attractive.
Is it because earnings are about to fall off a cliff ("cliff" reference intentional)? This is trickier. I honestly don't think the politicians can cause that by themselves. On the other hand, the global economy continues to deteriorate, so this risk is real. You are not being compensated for real default risk at these levels.
It is hard to tell what is driving things here. If it is the latter, then the sell-off may have more to go. If it is the other reasons, that can be corrected quickly.
Is the Chase for Yield Over?
Longer term, the answer is no. Our short-term rates will be low for a very long time. I would bet on four more years of that. Treasury yields will likely remain low too as the Fed will buy if they need to. So at some point people will look for yield, and all the reasons that credit looked appealing will remain in place. It is probably why investment grade bonds aren't seeing the same pace of outflows.
Then there is QE. It is funny that it is easier to ignore QE when risk assets are on sale (like now) and focus on QE when you can't source risk assets (like September). But there is $85 billion a month being put to work. Some is replacement money, but some is new money. While the ECB may be happy to come out with big plans for monetization that they have no intention of using, Ben uses what he says. He will not stop printing, and with the fiscal cliff in the hands of the "people" in Washington, he may use the dismal post-Sandy jobless claims as an excuse to push more easing, not less.
This pool of money coming from the Fed is growing. Right now it is not being deployed into risk assets, but if that changes, there may be more money to chase bonds up than there was when they were selling off.
So I don't think the chase for yield is over and I do think that ignoring the QE that is already out there, and more potential Fed programs, is dangerous. At 1,450 on S&P and 101 ¾ on HY19 it was easy to ignore what else QE could do. Not so much here.
Is the ETF Discount Real and Will It Last?
The simple calculations show that the two big ETFs are trading at a discount to NAV. With how illiquid the bond market is and how sketchy NAV is to begin with, I'm not convinced there is a real discount. For the arb to exist, you need to be able to hit a bid on bonds then redeem shares to get those bonds back. If you can get that done, then the sell-off and redemptions can perpetuate itself. If the bids aren't there and the ETFs are closer to a real NAV, then that risk is more remote.
We have spoken about why the arb tends to be particularly vicious on the downside. To a large extent it is risk neutral to the market (especially if redemptions are done for bonds rather than cash). I think the best way to describe it is the difference between having one $100 bill and one hundred $1 bills.
In either case you have $100. I don't know about you, but the two things are different. You tend to worry more about that single large bill. Stores will check it to make sure it isn't fraudulent. Some places won't accept it at all. If you drop it, all the money is gone. It is the same, but it isn't.
That is the same thing that happens with the arb. It leaves some people with $100 bills (the bond traders). They get nervous in a down market and sell. That ensures that the arb condition gets set again, as the $1 bill holders aren't as easily scared out of their position (the ETF owners).
Too Early, Too Late, or Just Right?
I'm certainly not selling HY here. The time to be out of it was ahead of the election. Is it time to add? My gut says yes, but there are real concerns about fiscal cliff, Greece, Spain, China, Israel, earnings, retail continuing to exit, and the possibility of an arb-led death spiral. With all those concerns out there it is easy to see why the answer is to sell.
I don't see the death spiral occurring as high-yield bond traders have the "good sense" to not bother making live bids. In CDS, the arb existed because the CDS market was just that much more liquid in times of stress than the bond market is.
Retail seems to be behaving rationally with their moves, so once the closed-end funds get a bit cheap, they won't be panicked by that and they will likely keep high allocations to fixed income. In fact, many who chased dividend stocks may finally realize the difference between stocks with big yields and bonds. That is probably asking too much, but I don't think we are seeing any sort of exodus.
Israel is a real wild card. I don't have a good answer for that and I don't have a good estimate for how big that problem is. I think likelihood of escalation is high, but I also think global disruption risk is lower than estimated. Regarding China, we need to see what the new leaders try to do.
On the fiscal cliff, Greece, and Europe, we seem to be at the same stage we've been a number of times before, including last November. As dark as it seems, they have the resources (printing presses) necessary and are more scared of contagion than they let on. Is this the time they think they can get away with Lehman II? I don't see it. Some might think that. Some are even hinting at that, but behind closed doors I think enough people will come to the conclusion that the risk is great, and even Germany might be seeing that this slow pace of barely keeping the patient alive is not leading to anything good.
So I think buy. Only small as the risks are high, but I think the risks will dissipate over the coming days and some are already overstated.