"Oh, that clock! Old killjoy. I hear you"
Exceptionally low interest rates, given enough time, can cause investors to do some pretty silly things. They helped fuel the housing bubble in the United States, as cheap and plentiful credit turned what started out as an increase in affordability for many families into a crazed speculative boom. We know how that story ended.
Since the collapse of the housing market and the resulting financial crisis, interest rates have again worked their "magic." Investors have been given a stark choice: Earn zero in nominal terms and watch inflation slowly eat away at their savings, or take a meaningful amount of risk in the hopes of generating at least some return.
Not surprisingly, over the past several years investors have bid up asset class after asset class, starting with longer duration government bonds (e.g. 10 yrs), followed by investment grade corporate bonds. As the juice was squeezed out of these assets investors have been forced to go further and further out on the risk spectrum including the equity market. Initially high quality, blue chip companies were the target of choice. As those securities were bid up, investors have chosen (arguably forced) to more and more risk, moving into assets such as small cap stocks and, notably, high yield debt. The proliferation of ETFs such as the SPDR Barclays High Yield Bond ETF (JNK) and the iShares iBoxx High Yield Corporate Bond Fund (HYG) have made buying high yield debt exposure very easy. Of course, selling is just a mouse click away now also.
The chart below gives a partial illustration of what has occurred. The green line is the 10-year US treasury yield, the blue line is the S&P 500 index, and the red line represents the Barclays US Corporate High Yield Total Return Index:
Just how hard has high yield debt come? The follow chart courtesy of the Federal Reserve Bank of St. Louis shows the spread over US treasury bonds of the BofA Merrill Lynch High Yield Index:
While the spreads have obviously narrowed substantially since the 2008 financial crisis, a bull might (correctly) point out that while spreads have declined, they are not yet at the levels seen in 2007.
While this is a fair point, it masks a very important distinction. Note the chart references the spread above the relevant treasury bonds. The US 5-year treasury bond was yielding approximately 4.5% in 2007. Today it yields about 1% (up from about 0.7% two weeks ago).
In that context, in looking at the absolute yield on high yield debt, we get a different picture, as the chart below shows:
As shown above, the returns on offer from high yield debt in general is at an all time low.
Not only do high yield bonds have exposure to interest rate risk, they are (more importantly) exposed to the risk of default, and in default the severity of default. There is a reason these are called "junk bonds" - they are very risky. For example, JNK declined about 45% during the crisis, and sell-off along with equities during "risk off" periods. But unlike equities which have theoretically unlimited upside, a bond with a 4-5% yield to maturity can return no more than that if held to maturity.
Regardless of what investors should or should not do, what they actually do matters to the rest of us. With that in mind there are some troubling signs in the high yield market. We believe we could be seeing the "canary in the coal mine" with a potential for a significant sell-off with or without a broader equity market decline or correction (which is arguably long overdue).
One of the interesting things about exchange traded funds is that, unlike closed-end funds, their share could shrink up and down on a daily basis as funds flow in and out of the ETFs. Fortunately for us, this data is available on a daily basis in the form of the shares outstanding number for any given ETF. This is an interesting metric as it reflects the true money flowing in and out of an ETF.
The most striking recent example of this continues to be the SPDR Gold Trust (GLD) ETF. As money flowed into the ETF, GLD in turn by mandate had to buy gold. When investors sell an ETF, the process works in reverse and the ETF is forced to sell gold. It is automatic. The chart below shows both the shares outstanding number for the GLD against its price:
What is startling about the chart above is that as the gold price has fallen (represented by the green line above), the ETF share count is collapsing as investors sell the ETF. Importantly, this contributes to further price declines as the ETF is forced to sell into a declining market. The GLD share count has declined by 25% already this year and is no doubt contributing to further pressure on the gold price.
Like gold, ETFs have been a major factor in the high yield market yield-seeking investors relentlessly poured money into ETFs and mutual funds, forcing them to buy whatever bonds are in the index. For example since 2008, JNK alone has seen its market capitalization increase from less than $1 Billion to over $12 Billion by Dec 31, 2012. HYG's market cap in December 2007 was about $350 million. It is now over $15 Billion. Other funds and mutual funds have also experienced massive inflows.
Over the past few months, there are cracks developing that could indicate the high yield debt market could be in for a rude awaking along with gold investors.
Whether it's a concern about interest rates, defaults, the realization that their high yield actually doesn't have a high yield, or they are simply sick of missing out on the equity rally, investors are beginning to pull money out of high yield debt funds. And it seems to be accelerating. The problem is that if substantially all of the buyers of high yield debt are forced sellers, who will be the buyers? Given investors' tendency to sell more aggressively the more prices decline, where could it bottom out?
The follow chart shows both the price (in green) and shares outstanding (white) for the JNK ETF for the past 5 years:
It looks much scarier on a 1-year scale:
As you can see, the price is only just now starting to catch up to the flows out of high yield ETFs. Like investors in gold have learned recently, what is thought of as a safe haven can be anything but.
Perhaps investors are also waking up to the fact that the dividend yield they are receiving on high yield ETFs is higher than the yields on the underlying securities. They are getting paid, in part, with their own money, as this table shows for JNK:
Of course the above yields are before a gross expense ratio of 0.40%, and assume a default rate of 0%.
As long as the music is playing, you've got to get up and dance"
- Chuck Prince, former CEO of Citibank
What happens when the music stops?
Additional disclosure: This article reflects my personal views only. I have a short position in JNK. All data and calculations presented are accurate to the best of my knowledge but have not been vetted, checked, proofread, or independently verified. This article should not be relied upon for any purpose other than for entertainment. I welcome comments and or corrections.