Falling crude prices, a federal rate hike of 25bps, and panic in global equity markets has caused a sharp increase in high-yield bond yields as prices plummet.
High-yield bonds returned less than -5% in 2015, including the interest payments on them. The year proved to be an absolute disaster for HY investors, and left many scrambling to get rid of their holdings. This quickly led to a decrease in liquidity in the market.
To predict future trends in the domestic HY credit market, it's very important to analyze crude prices, interest rates and high-yield credit spreads, and the equity market.
Crude's Impact on the HY Credit Market
Crude has always been one of the most volatile and actively traded commodities on Earth. In fact, many of the corporations that issue junk bonds are directly involved in the energy sector. As crude prices have fallen, these corporations have taken massive revenue hits, and therefore have encountered difficulties paying back creditors.
It is clear that HY bonds are substantially correlated with crude price. However, not as much as you would think. The correlation level between junk bonds and oil over the past five years is 0.31, 1 being perfect correlation. The correlation level has risen and continues to rise, with the correlation level over the past year at 0.36. As crude prices slide, more corporate energy bonds are rated as "junk," and as the commodity continues sliding, these securities lose value.
Below is a 5 year chart of (NYSEARCA:XLE), a popular ETF tracking crude prices:
The future of crude prices is largely dependent on both supply and demand and the "geopolitical disaster" that is the Middle East. The OPEC cartel, at the end of the day, plays the key role of determining crude prices. In mid-2014, they embarked on a quest of sorts to drive US producers out of the market. In doing so, they lost over $500 billion in revenues, while the US lost barely a fraction. The problem eventually became that US producers were sort of the "swing players," in that if prices increased, more producers would enter the market, which would lead to too much supply in the market, and prices would plummet. On the other hand, if prices decreased, OPEC would be in for another year of heavy revenue losses.
Another very important aspect of crude prices is the political side. As political tensions rise between Saudi Arabia and Iran, drops in oil prices are inevitable. Both countries are members of the cartel, and anything short of complete unification within the cartel will surely result in utter disaster for oil prices. America's part in all this is, of course, the nuclear accord with Iran. If this accord passes and is implemented, sanctions on Iran will be removed, meaning that the oil market will be oversupplied by an additional 500,000 barrels.
Now, oil is oversupplied by more than 1 million barrels per day (not including Iran's 500,000 barrels per day). OPEC continues to fail in their efforts to curb supply, and a strengthening dollar only makes the outlook for crude bleaker.
The Impact of Interest Rates and HY Credit Spreads
The Federal Reserve began a policy of "gradual" tightening in mid-December, and started by raising interest rates by 25bps. This had a relatively immediate effect on the commodities market, which was already fairing poorly to say the least.
According to a poll of leading economists conducted by the Financial Times, policymakers are expected to continue the monetary tightening in 2016. Most participants expect a total raise of 75bps within the year, most believing it will come in the form of three individual rate hikes. If this expected outcome materializes, rates would be at 1%, a landmark event in US monetary history considering rates had remained at near-zero levels for almost a decade.
The effects of these rate hikes will evidently have a negative effect on HY bond prices. From 1983 to 2013, HY bonds returned an average of 12.4% in expansive environments, and an average of 8.5% in restrictive environments. As rates contract, there has been a tendency for these high-risk securities to perform poorly, and the opposite is true as rates increase.
As rates have risen and are expected to rise, spreads have and will rise proportionally. As yields are incredibly high, issuers of these bonds are trying to pass of that they are "fairly compensating creditors," and have increased coupon rates. BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread pins the current spread at 17.03, a clearly significant difference from June 30 of 2014, at which it was 6.39.
What does this mean? Well, put very simply, the risk of default on these bonds now is more than twice as high as it was in June of 2014. Although they may be offering higher coupon rates, and therefore yielding higher spreads, when these junk bonds are defaulted upon due to a multitude of causes, investors will again be left with their jaws dropped, shocked at how they could be duped yet again.
Below is a chart showing high-yield bond spreads between mid-2011 and now:
Impact of Panic in Global Equities Markets on HY Credit Market
Perhaps the greatest factor that will lead to an even larger meltdown of HY debt is the collapse in global equities markets. George Soros, renowned for his legendary acumen, recently said that the market is reminiscent of the "crisis we had in 2008." Referring to the recent collapse in the Chinese equity market, which triggered multiple circuit breaks, he said "China has a major adjustment problem."
After Chinese production began to slow down in August, investors worried that the nation that had been dubbed "the future" was going to come to a grinding halt very soon.
On Thursday, the Chinese permitted the biggest devaluation in the renminbi in 5 months, highlighting the Chinese government's eagerness to stimulate staggering production. As China contracts, pressure is increased on equities around the world. Even massive QE programs by the ECB have been largely unsuccessful in stimulating the economies of the member nations, mainly due to constantly plummeting investor confidence as drops in the Chinese market continue.
The reverberations are being felt around the world, with global markets losing $2.3 trillion in market capitalization in only a week. The S&P 500 posted its worst opening week of all time, with the WSJ Market Data Group reporting "For the S&P 500-the first 5 trading days of the new year has predicted the direction of the full year 68% of the time." You want to know what's even scarier? The Dow Jones has a 0.99 correlation level with the S&P, making a meltdown in the Dow virtually synchronized with a meltdown in the S&P.
$12 billion exited the US equity market in just the first week of trading, furthering the collapse in the equity market. In fact, even the IMF is bearish on global equities markets, starting its report with the phrase "A return to robust and synchronized global expansion remains elusive." The IMF, which predicted lower GDP growth (the worst since the Great Depression), was by no means exaggerating the current market conditions we face.
Failing QE programs around the world coupled with China's devaluation of the renminbi have even caused investors to redeem $8.8 billion from funds that have equities invested around the globe.
The image below is a chart provided by Bloomberg:
It's very clear that global equities markets have performed atrociously in the first week of 2016. The fact that 68% of the time the first 5 trading days of the year determine the course of the economy for the rest of the year really gives cause to worry about the HY market. Could it flourish during a continuation of the global equities rout? Nope. So, with the probability that the equities market will continue to underperform for the foreseeable future, being long on HY credit securities would be an unintelligent decision.
Final Thoughts and Remarks
Many different forces exert pressure on the HY market, and that is why, at certain points, the future can look clouded and therefore difficult to predict. At this point in time, however, it seems as if all the forces have aligned themselves. Crude prices are being battered by the geopolitical problems of the Middle East and oversupply, interest rates are being raised, and global equities markets are in a rout. HY securities are most often thought to be a way to capture additional yield when the market is performing well. When the market is underperforming (as it has been and will continue to be) they should be viewed using their name "junk."
Junk Bond ETFs:
(NYSEARCA:HYG) - iShares iBoxx $ High Yield Corporate Bond ETF
(NYSEARCA:JNK) - SPDR Barclays High Yield Bond ETF
Both of these ETFs give a broad representation of the HY market, and can be used to gauge its performance. If you agree with the argument laid out in this article, you should short either one or both of these ETFs. If you have no interest in trading this market at all, but just have an interest in the HY market, add these ETFs to you watchlist. If you fail to see the points that have been clearly laid out and want to go long on HY bonds, go long on either one or both of these.
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.