High Yield Market Is Setting Up For A Pullback - Remain Cautious On BDCs

by: Parsimony Investment Research

Demand for high yield bonds (a.k.a. junk bonds) has steadily increased since the market lows in 2009 as investors have been desperately seeking yield in the current low interest rate environment. However, recent money flow data for this asset class may be signaling trouble ahead.

Data from EPFR Global showed a huge reversal of cash flow to U.S.-domiciled high-yield mutual funds and exchange-traded funds, as investors withdrew $1.58 billion for the week ended Nov. 23, based on weekly reporters only, compared with the $194 million inflow during the prior week. The outflow ends a six-week inflow streak, totaling $10.2 billion over that period. It also represents the largest outflow in 17 weeks, and the third single-largest weekly withdrawal of the year.

As shown in the chart of the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) below, the high yield bond market is already seeing the effects of the recent outflows. The recent rally fell short of making a new high last week and JNK has declined the past four sessions. Click to enlarge:

Loan fund flows have also been negative recently. Data from EPFR Global on fund flows and asset allocation showed a $215 million outflow from U.S. bank loan mutual funds and exchange-traded funds in the week ended Nov. 23. This is the third straight week of increasing outflows from loan funds, building on last week’s $185 million negative reading. Outflows over the past three weeks have totaled $518 million.

Trouble for Business Development Companies ("BDCs")?

Clearly, the threat of a European contagion is on the front of most investors' minds. The recent softness that we are seeing in the High Yield market is most likely tied to this ongoing fear. That said, if the situation in Europe intensifies, credit markets worldwide will definitely feel the repercussions. This may spell trouble for BDCs, which invest in the debt and equity of small businesses.

The table below lists the largest BDCs by market capitalization. Despite mostly attractive yields, BDCs generally trade at a discount to book value and they tend to have high relative betas.

Many BDCs went under during the last recession due to the loose credit underwriting standards of the leveraged buyout boom of 2006 and 2007. Also, dividends can get shut off very quickly when times get tough (just ask longtime ACAS shareholders). While we don't expect this situation to be as dire as in previous economic corrections, BDC stocks may take it on the chin in the short term and investors should remain cautious on the space.

Here is a good article from a fellow SA contributor detailing the impact of a potential recession on the BDC industry.

As their high beta suggests, BDCs tend to outperform the market when times are good and underperform the market when times are bad. As shown in the table below, all five of the BDCs listed above have underperformed JNK (bold blue line) over the past year (on a dividend-adjusted basis). Click to enlarge:

Investors would be wise to remain cautious on BDCs until the High Yield market shows some signs of stability.

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