All the bond guys I run into like to remind me that they are smarter than equity investors. I invest primarily in equities, a wee bit in high yield bonds and trade derivatives. I can't recall the last time I truly felt smart. I have made some money through various investments, but I can't recall the last time where a truly smart derivatives structure was responsible for a majority of my gains, or a truly smart unknown stock I bought resulted in outsized gains in my portfolio. This is because investing smartly doesn't require one to be smart. It requires one to have common sense and common sense is telling me to be very very careful with high yield credit these days.
In my previous post on high yield titled "Are you whistling Dixie with high yield", I laid out some reasoning for some troubling signs I had observed in the high yield space. This got me doing some more work, and the more work I did, the more trouble I uncovered. Maybe it is my confirmation bias at play, but common sense tells me that the odds of a favorable outcome for high yield right here, right now are not high.
Let's look at the trifecta of trouble I have spotted in the high yield space:
1) High yield ETFs are being liquidated: High yield bonds are somewhere between equities and investment grade corporate bonds in terms of their volatility and risk. As a result, a high yield market where investors are putting new money to work creates a virtuous circle where more bonds are issued, liquidity is good and everyone is feeling merry. This stops the moment people begin leaving the party because when people take their money and leave, the remaining people have to scrounge together enough cash to buy the securities from those people leaving. Liquidity begins drying up and we get deterioration in sentiment and in turn, a deterioration in credit. Right now, we are a stage where people are just beginning to leave the party. The sentiment has not soured, but any negative catalyst can quickly change sentiment. The chart below is a custom chart I have created which measures the shares outstanding for all the large HY ETFs combined. The recent trend shows that inflows topped out in April and outflows have begun recently.
2) Shorts are circling high yield: It takes real brass cojones to short high yield. Why? Because when you short, you have to pay your prime broker for the borrow and you also have to pay the yield outstanding on the security. The current yield stands around 5.2% for iShares High Yield (NYSEARCA:HYG) and 6.15% for SPDR High Yield (NYSEARCA:JNK). The cost of being wrong therefore isn't just that the price changes but the price change + the yield. So when a short begins leaning into high yield, that person has real cojones and conviction. Well, we just happen to have such people beginning to short high yield funds. Here is a graph to illustrate the short interest in the space:
3) Bearish option activity abound: One of the ratios I look for in any trade is the number of people betting with or against the security in mind. In case of high yield funds, there are many people betting that prices will fall. Perhaps they are betting on the fact that accelerating high yield defaults will eventually lead prices lower. Perhaps they are feeling lucky and want to waste money on lottery tickets. I think the former is true. Defaults have been piling up and with energy being a large weight in high yield, it is no surprise! Guess what, a break lower in oil will most certainly put additional pressure on HYG, JNK and related instruments.
Now I am not a huge fan of following lemmings into a trade. I usually like to wait until the trade is heavily favored one way so I can quietly move into the other end. But in this case, a spike in put option open interest has been quite prescient before - something about bond guys being smarter perhaps? Notice that the last spike in put options outstanding was around June/July of 2014. Notice how the high yield trade played out in the following months below:
Not pretty. As in, a capital loss of 17%.
When one decides that in the face of a combination of lower liquidity, higher short interest and increased bearish option trades that buying high yield credit is a good idea, I say to him, "You are a brave soul Sir and I wish you well." I wouldn't do that trade because I ain't no hero, at least as far as losing money is concerned because I like money like I like my trees. Green and growing. My last article also touched on the narrowing spreads in the space, which is another big warning sign and if you want to gain a couple of more insights, I would highly encourage you to read it.
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.