Moving to Neutral on High Yield

Includes: DIA, HYG, IWR, JNK, SH, SJB, SPY
by: Peter Tchir

I've covered my HYG short, which is actually a SJB long. The move has been big. I'm cutting it, but cutting it reluctantly. Many of the reasons that I originally thought the trade made sense are still in place. They indicate further downside risk, but for the moment I'm happy to take some money of the table as I remain concerned that governements or central banks will attempt to rush to the rescue with some new half baked idea, or resurrecting some old half baked idea that didn't work but investors love to buy on.

There are two main reasons that the best I can get to is neutral, and the shares outstanding on HYG have not dropped much. Same with JNKSO. They have both rebounded to levels back in early June. To me, that indicates that this move down is without significant outflows. Moves like we have seen this past week (six months or more worth of income) tend to cause people to reduce exposure. If we see outflows there could be more downside to come. And remember, I have a strong view that ETF's have a bias that they get crammed full of the least liquidity paper whenever we get inflection points. That would be very bad in a time like this. We will see if it turns out to be a correct view. I've been told about some managed high yield ETF's. I haven't had a chance to look at them yet, but that seems intriguing.

The other main reason I can't get bullish is that the CDX HY index is not trading particularly cheap. My best guess is that it is trading about 1 point cheap today (though it is hard to pin down when the market is so volatile). Typically, when we are near the end of a panic move down, the high yield index will trade 2 or 3 points cheap to fair value. That is an indication that all the fast money shorts have piled in, and longs who were reluctant to sell their beloved cash bonds had shorted the index to attempt to reduce the mark to market pain. We aren't seeing that yet. It is as though the credit markets didn't believe in the equity sell off and still don't really think we have hit new levels. I think people are still long and underhedged, and would be more comfortable buying the dip if the index was trading so cheap to intrinsics that it was obvious everyone had capitulated.

I wonder if there were any hedge funds running 2x leveraged money in high yield. They would need to in order to get 14% raw returns and hit 10% after fees if they were buying 8% paper. They got marked down 4-6% today, conservatively. There will be some unhappy strategy sessions tonight, and some ugly morning meetings. I wonder how many kept some powder dry so they could buy when things finally got cheap? And of those who did, how many will have the courage to add rather than cut?

Disclosure: I am short SPY.

Additional disclosure: I may switch to long SPY or HYG or may re-initiate short in HYG.