Back on June 3, I came out bearish high yield with a recommendation to short the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) or SPDR Barclays Capital High Yield Bond (JNK) or to buy SPDR Barclays Capital High Yield Bond (SJB). That was based on several factors I was seeing in the market at the time:
- CDX indices were trading very cheap to intrinsic value
- slightly old new issues were struggling
- other markets, commercial mortgage-backed securities (CMBX) in particular, but European credit as well were extremely weak and were starting to leak into corporate credit markets.
Since then I have become more neutral on the market as it has had a significant decline (HYG went from 91.30 June 1, to 87.88 last Thursday). CMBX stabilized, we were near the 200 day moving average on the S&P 500 (SPY) and a lot of other risk assets and there was another obvious attempt to figure out a Greek solution.
I am back to being bearish the high yield market. I am not yet short it, but I would certainly recommend being underweight right now.
A couple of things have pushed me back to being bearish. The main one is weakness in other credit markets. Once again CMBX is heading lower and back at or near its recent lows. It has not been able to sustain a big rally, which is particularly surprising because it is relatively illiquid and is a 'hedge' trade so it's usually very exposed to a violent short squeeze. Irish and Portuguese 10 year bonds hit new record yields according to Bloomberg - 11.47% and 10.99% respectively at the time of this writing, though Portugal broke 11% earlier in the day.
I have argued that 'solving' Greece does not stop the potential contagion, just that it wouldn't be the first domino. The realized losses on Greek bonds in the event of a default or restructuring with principal write-downs would hurt other banks and put pressure on the entire system. That seems like it might be avoided for a while longer (though whether longer is a week or a year is anyone's guess). The problems Ireland and Portugal and other over indebted countries face have not changed. The contagion risk is still there, it just seems more likely that it will be triggered by another country, or else the EU will have to fight bailout fatigue and save another country, again, soon enough.
The 'fundamentals' of HYG and JNK are also scaring me enough to revert to being bearish. HYG saw its shares outstanding remain stable for the first time since early June, but JNK saw another small reduction, even after relatively large ones on Thursday and Monday. If the outflows continue, it will be hard for high yield to maintain current prices, particularly given how illiquid it currently is. And how can you tell how illiquid it currently is? Last Thursday's price move in HYG bears closer scrutiny.
The relative performance of the price of HYG and the net asset value (NAV) of HYG on Thursday and the subsequent price action is a clear warning sign that liquidity has broken down in high yield. Last Thursday, HYG dropped almost 2%, and (with the ETF already trading slightly cheap to the NAV), NAV dropped only about 1/2%. That is a sign of lack of the liquidity in the market. Trading volumes dropped and bid/offers widened forcing even institutional investors to cut exposure via ETF and CDS indices rather than selling bonds. HYG has performed well since that Thursday - as have almost all other 'risk' assets. What concerns me is that NAV continued to drift down Friday and Monday. Clearly investors were waiting to sell some high yield bonds into strength. I would be more optimistic for a strong bounce if the NAV had not leaked lower for 2 more days. It did finally go up yesterday, but HYG finished up almost a point yesterday, so a 1/4 point uptick in NAV on HYG is just not that bullish of a sign.
With the combination of weakness in other credit markets, coupled by the HYG NAV confirming that liquidity is at an extreme low in the high yield bond market, I think it is prudent to cut high yield risk. With European credit closing quite weakly, I may shift to an outright short.
Disclosure: I am short SPY. I may initiate short positions in HYG/JNK or a long position in SJB which is the inverse of HYG.