Is High Yield Signaling An All Clear?

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Includes: HYG, IYF, JNK, SPY
by: Bruce Pile

Summary

The high yield debt market is showing some encouraging signs of life lately.

The higher risk credit market is typically the first to recover in a down debt cycle, and bears close watching.

To verify the improvement over the last 15 months, a larger scale view is required, especially in the upgrade/downgrade cycle.

In case you haven't noticed, the high yield credit market has been rejuvenated lately to unbear-like behavior. The HYG high yield corporate bond ETF is actually up more than the Dow YDT, putting it ahead of about everything except utilities and gold. The inflows into these bonds have been looking up recently as an article "High Yield Market Technicals" just out by AdvisorShares points out.

Why Care About High Yield Bonds If You're A Stock Investor?

Why is this important? I watch this because one of my principle maxims is that the credit market leads the equity market. It usually is the early warning for any major change in market complexion. I watch bonds mainly for early warning on downturns, because the warning is typically very early and pronounced. But high yield also tends to turn up ahead of stocks at the end of declines too. If you look at HYG vs. SPX in the September, 2008 to March, 2009 time frame, you see HYG not making a new low on March 9 and getting back to pre-crisis levels much sooner than stocks.

So is this more risk sensitive area of debt now showing a turn for the better? Well, for all of 2015, this area experienced a $7.1 billion net outflow of funds whereas just the first three months of this year saw a $6.1 billion inflow! That is a strong turn, especially considering that commodity prices, the predominate affliction with high yield, remain very weak and are not making any such big turn. But to see if the debt market is really signaling any big turn up, we have to step back a few paces and look at this 15-month change in fund flows in context:

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Here we see the market leading nature of the Russell leading the Dow downturn and the debt market leading the Russell. Debt made the bear turn a year before the small caps of the Russell, and the leading small caps have not rallied to anywhere near new all-time highs as the Dow has done. I wrote a whole article on these megaphone formations, as they have been a feature of every major US bear market since 1850. The graph above suggests that the good year high yield flows are having so far compared to 2015 is just a bear rally in the bigger picture. However, HYG is at a critical juncture now, and if it were to do a convincing breakout from the down-trending progression shown above, it would likely be our first good clue of a positive stock market ahead.

It's All About Oil

Much analytical effort is being focused on the energy companies, the high yield bogeyman, as to when and if they will recover from the oil price slump, and ease the high yield problems and thus the stock market. The price of oil is a mystery wrapped in a puzzle and locked in a safe with the combination encrypted by Apple (NASDAQ:AAPL) with no back door. You can tabulate rig counts, inventory build, break-even price for the drillers, and geopolitics all you want, but nobody really knows what the oil price is going to do. And it is so important because it pulls around the massive debt market, which in turn pulls around the whole stock market. So we'd really like to know what it's going to do.

Even if you don't own a single energy name, stock investors should care about oil these days because of the energy company debt dominoes all linked together with a record amount of derivatives, with these all wrapped around the big banks, which wrap themselves around everything. It is credit defaults in high yield that is the problem, and these may be a big problem even if oil climbs back to $60 a barrel.

EOG Resources (EOG) has said that it will not unpack mothballed production until the oil price is over $60, and they are one of the more cost efficient major producers. A recent article "Shale Producers Can't Make Money At An Oil Price of $60" did an in-depth tabulation of all this, which is corroborated by a Forbes piece "Big Oil Gears Up For $60 Break-even Price As Profits Sink." Opinions vary with WoodMackenzie saying most shales can be drilled for profit at $50, but the consensus seems to be more like $60. However, improving technology has this break-even point edging down. The point is that we could see a very nice rally in oil from $38 and still see a very dangerous wave of bankruptcies in the months ahead.

This basic problem is borne out by a credit downgrade/upgrade graph the AdvisorShares article shows:

This is for all sectors, but as we all know, the majority of problems are now in energy. The gray bars show the companies that have been downgraded from investment grade to high yield while the blue bars show the companies that have been upgraded out of high yield to investment grade. It is very bearish to see that 2015 saw an extreme level of credit downgrades only matched in 2002 and 2009 - the two worst previous bear market years. There is a 3-month lag between downgrades and the additions to this index. So there could be a lot of late 2015 downgrades yet to be added to the 2016 total.

What is truly scary is that the downgrade bar we see for 2016 is just for the first quarter of this year! This rapidly deteriorating credit situation may be much more significant than any $10 move in oil. We seem to want to feel safe if oil pokes its nose above $40. But, even if oil stabilizes at $40-$60, where it has resided for all but 3 of the last 16 months, we could still see a continuation of this:

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We hear the opinion that these energy defaults are no big deal. It reminds me of the "sub-prime is contained" mantra of 2007. Well, this level of credit trouble was a big deal in 2002 and in 2009 in the downgrade graph above. It was associated with the two previous horrendous bear markets. And that seems to be the market's opinion now. If you look at the XLF (US financials), you see that they are lagging this rally of the last couple of months very badly. And the non-US banks are lagging much worse. The market seems to think the defaults are a big deal.

In case you are wondering if the whole US bond situation, outside of high yield and energy, is looking anywhere near this bad, Barron's had an article out March 24 by Amey Stone with the rather unsettling title "Standard and Poor's: Average Corporate Credit Rating At 15-Year Low." The opening line of the piece goes, "When any metric related to credit looks worse now than it did in 2009, in the midst of the financial crisis, investors should sit up and take notice." I couldn't agree more. We have had a massive historical "deformation" as David Stockman, Reagan's former OMB chief, calls it in his book "The Great Deformation." There has been a dislocation in the whole credit landscape because of zero cost debt for over 8 years.

There has never been anything like this in banking history, and now we are playing with fire as a result. Credit analyst David Tesher gives a forward-looking view in the Barron's article:

A re-calibrated, smaller, and more conservative lending environment, where restricted capital market access will enable lenders to better dictate terms and conditions, could prompt liquidity challenges, accelerate downgrades, and ultimately lead to a spike in defaults.

End Or Beginning Of A Bear Market?

In the downgrade chart above, the previous downgrade fiascoes of 2002 and 2009 were years at the end of bear markets. Are we there now? Well, let's see. We are within about 3% of the all time high on the Dow. The Fed is jawboning a normalization of rates because the economy is so good. And the 2016 credit downgrade total looks to be at least 4 times as bad as 2015 with nil upgrades compared to any year in the past. Looking at the graph, downgrades fell precipitously in the years following '02 and '09, but they are rising sharply this year. Call me crazy, but I'm saying it's more like the beginning of a bear.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.