Over the past eight months, the yield on the US Treasury 10-Year note has been trading in a sideways range.
It's back over 3% this morning, only 12 basis points shy off its recent multi-year high of 3.128% from mid-May this year.
Between 3.5% to 2.5%, we believe that the next stop is more likely to be the former. More than hitting any of the end-points, it's the direction (upwards) we are more convinced of. We discussed the reasons behind this possible move in various articles recently:
- The Great Divergence: It Won't Last Much Longer
- 'What A Wonderful World'? Well, That Very Much Depends Where You Look
- Will This Time Be Different? I Strongly Doubt That. So Should You!
- While The S&P 500 Is Close To An All-Time High, There Are So Many Assets At Record Lows
- S&P 500: It's All In The Numbers And The Numbers Never Lie
While, in the US, yields are threatening to break into new highs; for the rest of the world, it's far from being so hawkish (when it comes to rates/yields).
The world is full of debt. As a matter of fact, the word has never been more dependent on debt than it is right now.
Whenever you look, you see debt. Tons of debt.
However, there's one place that is more sensitive to the size of debt on one hand and to the rising rates/yields on the other hand: High Yield ("HY") bonds.
(*) It's important to note that when I say HY, I refer to those with medium- to long-term duration. For the sake of simplicity, I would refer to HY in this article as any junk bond with a duration greater than 3-4 years.
Over the next decade, more than $4T of HY bonds and leveraged loans will mature (globally) and need to be refinanced.
Think of the size. $4T; that's trillions in case you thought the T to be representing AT&T. Now please also think for a minute where rates/yields were over the past decade and where they are (already now or) expected to be over the next decade. See the problem? $4T will need to be refinanced at a much higher rate and likely at a time where the world will be at or near recession. It can't get any worse than this.
You would think that the clever credit traders out there will position themselves accordingly. You may wish to think again. US high yield credit (HYG, JNK) spreads move down to as low as 329 bps. That's as tightest as they were since April this year and, listen/read carefully!, only 7 bps away from the tightest levels we've seen since July 2007!!!
Comparing the HY spreads to short-term rates/gauges (6-month IV in this case) is perhaps even more accurate because it looks at things from a relative perspective (i.e. versus a benchmark). As you can see below, not only that it's not looking any better, but we are actually at rock bottom.
As a side note, you may find it interesting that the spread between the 10-Year Treasury Yield (3%) to the 5-Year Treasury Yield (2.91%) is as narrow as it was since July 2007.
Do you see the irony here? On one hand, we have the safest assets in the credit market, i.e. US Treasury debts, pointing at an upcoming recession (the yield curve getting closer and closer to inverting) and on the very same time, we have the least safe debts, i.e. HY bonds, trading the exact same way (record-low spreads).
If this would be happening when central banks were running QE and/or loosening monetary policies and while we weren't that late in the current bull/economic cycle - I could understand this. It would still fall under "can't justify this type of greediness", but I could understand where it's coming from.
However, when such greediness is happening at a time when 2 out of 3 major central banks are tightening/scaling back and when we are so late along the cycle, I have other adjectives to describe these phenomena and none of those would be approved by SA to get published as is.
In case this wasn't clear enough for you: Do not buy HY with duration of more than 3-4 years. It's very likely you are going to lose money on those over the next couple of years.
Of course, many investors say that since they buy and hold to maturity - they care less about the price along the way. That's a common mistake and let me explain why by using a simple example.
Let's assume that I buy today a bond with 10-year duration/tenor (doesn't matter for the sake of this example) that pays 5% yield p.a.
Let's also assume that the same company/type of debt pays 4% yield p.a. on a 3-year duration/tenor bond and 4.5% yield p.a. on a 7-year bond.
Let's also assume that three years from now, the 4%, 4.5%, and 5% yields on the 3, 7, and 10-year, respectively, bonds are now yielding 5.5%, 6.5%, and 7.5%, i.e. spreads widen and the (HY!) yield curve steepened.
One can decide to buy the 10-year, 5% yield and make in total a 50% (nominal) total return over the tenor of the bond.
Alternatively, one can decide to invest today into the 3-year bond getting only 4% p.a. and then, in three years' time, invest into the (then prevailing) 7-year bond paying 6% p.a.
In that case, the investor will get 3-year X 4%+7-year X 6.5% or 57.5% (nominally) in total. That's, of course, better than getting only 50%.
If you assume that yields on HY debts may move even more than presented in the above example - the gap is going to be even greater, in favor of playing short duration initially and only then a longer-duration.
Those are time to take less risk and more hedging. This can be in the form of an overweight allocation to the US at the expense of Europe as well as in a shift towards more value to income at the expense of growth and momentum.
If there is one place you wish to avoid putting new money to work these days, it's medium- to long-term duration high yield debts. It's not only a debt wall HY bonds are facing, it's a death trap many corporations (that borrow a lot at low rates) are going to face in years to come.
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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.