You Still Don't Get It, Do You?

| About: iShares iBoxx (HYG)
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Do you understand your bond ETFs and funds?

You need to - especially if you own any junk (which we affectionately call "high yield").

Could your manager sell what your money is buying if he or she had to? And at what price?

Ok, let's go over this again, because I am still not convinced everyone gets it.

High yield is high yield for a reason. The reason is that the companies issuing it belong in a salvage yard at best and a landfill at worst. That's why they're called junk bonds.

Previously, it was harder for people to buy them. Why? Because easily accessible funds that invest in relatively esoteric parts of the bond market hadn't proliferated yet. Now they have. Now anyone with an E*trade account can become a fixed income trader. Yay.

(Chart: Citi with my additions)

Even "better," ETFs provide daily liquidity, which means mom and pop can easily trade in and out of their fixed income positions. Hooray for price discovery! Here's a look at retail ownership of HY. As you can see, the post-crisis peak was around 2012, but we're still at the highest levels since the aftermath of the dot-com crash:

(Chart: BofAML with my additions)

Make no mistake, this represents the complete abandonment of anything that even approximates common sense. It's an egregious aberration vividly depicted in the following simple chart:

(Chart: Deutsche Bank)

Obviously, this has been to some extent a function of ZIRP and QE. Investors are being herded into corporate credit (and subsequently pushed down the quality ladder) as the yield on riskless government bonds falls and eventually goes negative. Demand for IG, HY, and equity issuance rises as investors frantically search for some semblance of return.

So what, exactly, is the problem? Well, I've gone over it using analogies, stories, and technical discussions, so I'll be brief in recounting the issues before showing you some new charts.

People like bond ETFs because they can trade them easily. There's "liquidity." Only there's not. It's an illusion made possible by what Barclays calls "diversifiable flows." That's not as complicated as it sounds. When one manager has outflows (i.e. people are selling), he simply swaps portfolio products with another manager who is experiencing inflows (i.e. people are buying).


Note that there's no middleman in that equation. You'll also note that no one there is actually buying or selling any bonds. And therein lies the absurdity. Here's how the system worked before the crisis:


There's a middleman (Wall Street), and the underlying assets (the bonds) are actually being bought and sold. That's liquidity.

So you should be asking yourself the following simple question with regard to the first diagram above: "now wait just a minute here, what happens when there's no one on the right side of the grey arrow?"

And here's a followup question you should also pose to yourself: "what happens when the flows are not diversifiable but rather unidirectional?"

And a third, simpler question you might also want to ponder: "how does a model with no middleman work when everyone is selling their ETFs at once?"

Let me answer those three questions in order:

  1. there's a problem
  2. the underlying bonds have to be sold to meet redemptions
  3. it doesn't

Without Wall Street to inventory the paper, there are fewer buyers for the actual cash bonds. In other words: the market for the assets your ETFs are based on is very, very thin. And importantly, the practice of swapping portfolio products when flows are diversifiable makes it even thinner (everyone is habitually avoiding the actual buying and selling of the bonds).

Ok, got it. But why would everyone suddenly sell their bond ETFs and funds? Well there are a lot of reasons, not the least of which is the looming threat of HY energy's complete collapse. Guess what folks? Uneconomic US oil production isn't going to outlast OPEC. Yes, Saudi Arabia might end up going broke. Yes, the Gulf monarchies are tapping debt markets to fund widening budget gaps. But collectively they've got a lot of borrowing capacity, a lot of oil, and a lot of reserves:

(Charts: Deutsche Bank)

And don't forget about Iran, who has promised to keep pumping "even if oil goes to $20."

The point is, if the market gets spooked by further bankruptcies and defaults from beleaguered energy companies who are finally forced to throw in the towel, you'll get selling pressure on HY funds.

So that's a good story and all, but what are the actual numbers? Well, let's have a look. Here's HY leverage including and excluding energy names:

(Chart: Citi)

And have a look at these rather alarming bar charts. Hopefully, you would have been able to see the glaring problem on your own, but just in case, I've highlighted it for you:

(Charts: BofAML)

Here's some color from BofAML:

With the commodities rout, a much larger proportion of high yield has negative earnings today than immediately following the crisis or pre-2009. Chart 5 below shows inflation-adjusted earnings for US high yield by $150mn buckets (all in 2000 dollars). And as Chart 6 shows, on an inflation-adjusted GAAP EBITDA basis, the lowest quality non-commodity high yield (2015) is worse than the non-TMT 2000, 2010 and 2005 markets as well, suggesting borrower quality in the weakest part of high yield, in real terms, has in fact deteriorated post crises, not improved.

How about another fun graphic? What I've done below is take Goldman's forecast of HY spreads and dropped in an inset from BofAML that shows HY issuer default rates:

(Chart: Goldman; inset: BofAML)

See a possible discrepancy there?

Another problem is that HY credit doesn't seem to be very good at pricing vol. lately. The graph below is the iShares iBoxx $ High Yield Corp Bond ETF (NYSEARCA:HYG) with an inset depicting how the options market was pricing volatility in the weeks leading up to the UK referendum:

(Chart: Heisenberg; inset: BofAML)

Ultimately, the question is this: if you get a wave of ETF and fund selling triggered by a HY meltdown and managers are actually forced to sell the underlying bonds to meet redemptions, who is going to buy them?

Not Wall Street.

Who is going to want HY energy bonds (for instance) knowing that the defaults are spreading? If they're not completely illiquid, they'll have to be sold at a big discount and that means falling prices and thus steep declines in the ETFs and NAVs.

I'll close with one last quote from BofAML:

And given the stalled high yield rally over the last 6 weeks, should oil fall and fear replace a search for yield mentality, we think outflows, ETF selling and profit taking are likely to ensue. We think it's important to remind investors that the market has been completely propped up of late by the significant outperformance of Energy, Metals, and Mining, but conviction remains low at the broadest levels.

We believe the credit cycle is currently in its latter innings as the growth process has arguably stalled if not begun to slip backwards. Although Draghi, Kuroda and Yellen are doing their best, monetary policy can only be as useful as fiscal policy allows. And although our belief is that eventually deteriorating corporate earnings will lead to layoffs, a collapse in consumer confidence and spending and ultimately a recession, we also believe that an increasingly compelling case can be made that in between bouts of volatility our rolling blackout scenario may become the norm for much longer than any of us can anticipate. Under such circumstances the most levered companies with the poorest earning potential, those disrupted by technological innovation, and issuers relying on constantly open capital markets would trade at distressed-type levels.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.