If we decompose credit spreads into two components: (1) default premium and (2) liquidity premium then we can create a rule of thumb based on historical relationships that suggests the following:
Spread = (Default Rate x (1 - Recovery Rate)) + Liquidity Premium
Current Fair Value Spreads can be estimated at: (350 x (1 - 35%)) + 325 = 553
Fundamentally the HYB Index appears fairly valued given current 546 spread (11/8/2012).
There could be an argument made that the liquidity premium may be underestimated by Mr. Market. As the regression chart below suggests recent VIX levels may bias towards a wider spread closer to 594. The liquidity premium correlates well with fear gauges such as the VIX Index.
If risk-off continues spreads ought to widen given risk aversion.
While there is not an imminent threat of a major exodus out of High Yield based on fundamentals, one should know the potential unraveling of position reductions across various market participant portfolios. A renewed recession could change the fundamental outlook in a material manner triggering a rapid widening in spreads.
Retail: The retail investor in a yield-starved environment has sought after higher yields. Hence, inflows into HY ETF vehicles have been robust as well as flows into 40-Act funds. The fact that ETFs typically have been in "creation mode" has been a healthy backdrop for the supply of new net issuance seen in the HY market. The ability to offer penny bid-ask spreads for the HY ETFs has been well supported by market makers and other market participants supplying liquidity. However, this penny spread may only work as long as there is one-sided demand and creation of new units.
Institutional: Credit strategies have seen increased interest by non-traditional investors such as Hedge Funds and Private Equity firms. The leverage component here is what matters along with the allocation effect towards credit strategies in general. In any forced selling environment the liquidity demanded in a risk-off scenario can trigger severe widening in bid-ask spreads as well as overall credit spread widening.
The Threat of "Bid Lists"
Whenever Institutional buyers demand liquidity they oftentimes engage in creating "Bid Lists". This is an attempt for sellers to receive competitive bids on bonds being liquidated. 2008/2009 saw the effect of how severely liquidity premiums can widen as sellers far outnumber buyers who seemed to want to sell at almost any price. Back then at least you had trading desks at major banks and other buyers with "dry powder" to bid aggressively on bonds. This in turn created some mouth watering opportunities as subsequent years showed.
The current environment is somewhat different in that the backup buyers such as bank prop desks and fixed income trading desks have shrunk both in headcount as well as capitalization and allocation of risk capital. New regulations and reduced risk tolerances are to blame. This new landscape could present with risks in a severe and sustained risk-off scenario.
Consider what if ETF flows reverse meaningfully at some point? This may create a selling stampede by Institutional investors as well as retail money causing dislocations in the wider bid-ask spread environments in single credit space when trying to redeem ETF units and sell underlying single credit names. The effect would be an unattractive widening in bid-ask spreads on top of any wider credit spreads as a result of the sum of both fundamentals and liquidity premiums being repriced. The typical bid-ask spread in the HY market can range from 0.75% to 2% and as high as 4% for certain issues. In a sell-mode market these spreads could widen significantly creating dislocations penalizing sellers into this type of market environment. The big take away from this paragraph is that, the ETF penny spread in bid-ask may widen significantly if liquidity demand far outpaces supply. Note that already many HY ETFs underperform their respective index benchmarks due to trading costs - no accident given the "illusion" of liquidity for ETF vehicle versus underlying issues with less liquidity.
The speed at which high yield bonds could deteriorate could be meaningful if a vicious cycle ensues. Fundamental deterioration, with the fat-tail risk of another recession, causing credit spreads to widen as well as the leverage and retail outflow induced unwinding of positions demanding liquidity could create yet another episode of price dislocations.
Key Take Aways
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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