Over the past two weeks I wrote a few articles about the scary high-yield (" HY") space:
- History In The Making: Hope For The Best, Prepare For The Worst
- The Great Divergence: It Won't Last Much Longer.
- What Credit/Yield-Based Models Suggest About The Odds Of A Recession Coming Soon?
So much so that I even dared i) calling medium-to-long duration HY bonds (HYG, JNK) "The Worst Place To Put Money To Work Right Now" and ii) describing those investing in this space as "Walking Towards And/Or Blindly Falling Off The Cliff"
Harsh? perhaps. Justified? certainly!
As a matter of fact, things are only looking bleaker for HY credits
Allow me to try to spell this out as clearly as I can just one more time (for now...)
At 3.10%, the yield on the US Treasury 10-year ("UST10Y) debt is getting closer and closer to break the current cycle's high of 3.128%.
Nonetheless, let's put aside the fact that both short-term (BIL, SHY) and long-term (IEF, TLT) US Treasury yields are trading at multi-year highs. We are all fully aware of the effect that higher treasury yields have on corporate bonds. Instead of i) the simple (though strong) trade-off that exists in bonds (higher yields = lower prices), and ii) the extremely low spreads that HY credits currently trade at, let's take a look at additional factors/effects. They all point at only one possible direction for HY bonds.
Time to celebrate? Not so fast folks, not so fast.
First of all, let's not forget a simple fact: EM total debt is fast approaching $60T, or 200% of their GDP. The EM debt wall is very high!
Secondly, if things were so rosy, bid-ask spreads wouldn't widen that much as they do/did:
According to Bloomberg Intelligence's Damian Sassower, liquidity in EM HY debts has dried up steadily this year. Average bid-ask spreads in the space have widened by about 50% so far this year.
This extreme widening illustrates a broader market phenomenon: the extent to which years of ample global financial liquidity repressed investor appreciation of liquidity risk. Well, 1. No more!, and 2. It may only be the beginning of it.
Finally, Goldman Sachs (GS) shows that over $1.3 trillion (20%) and $3 trillion (47%) of total debt outstanding is set to mature through 2020 and 2023. HY, traditionally issued with shorter duration compared to investment-grade debts, is having a significant "representation" among these figures.
Source: Goldman Sachs
Recall that we wrote about the "European Bluff," stating that "Europe (VGK, EZU) is doomed." Guess what? The ECB walking out of the European credit markets is going to affect few EM countries, on top of the Eurozone's - member obvious - immediate suspects such as Italy (EWI), Spain (EWP) and/or Portugal (PGAL).
According to Nomura (NMR), a big chunk of the ECB QE money went to Russia (RSX), Argentina (ARGT), Peru (EPU), Sweden (EWD), and Mexico (EWW). These countries will be the most affected by the termination of the ECB QE program.
Inflation is heating across many leading countries/regions and no, we don't refer to Venezuela, Argentina or Turkey (TUR).
This means more rate hikes and more tightening of monetary policies in both North America and Europe. This is bad news for EMs that rely on and benefit from the easy money that was partially invested in them.
As a side note it's interesting to note that while the market is currently anticipating Fed Funds rate to be 2.75-3% a year from now, the ECB's Deposit Rate is expected to remain within negative territory. That is bullish for the US dollar (UUP) and, in return (once again), bad for EM.
The thing is that inflation may climb higher real soon. The reason/driver? Energy prices. Brent Crude Oil ("BCO") closed yesterday (9/24/2018) above $80 for the first time since November 2014. It's up 190% from its January 2016's $27 low.
The price of BCO is highly correlated with inflation expectations that are at their highest level since February 2018, and not too far off their highest level since 2014.
Taking into consideration where BCO and inflation expectations are, it won't be a wild guess to expect higher inflation figures real soon.
There are places where the weakness is already felt. According to Bloomberg and Barclays' (NYSE:BCS) data, bonds of junk-rated auto companies have fallen 4% so far this year, underperforming the broader HY index by more than 6%.
Source: Bloomberg, Barclays
This has been a year of divergence (for many assets/markets), especially as US policy threatens to alter supply chains.
Furthermore, covenants on risky debt (that are supposed to protect investors) keep deteriorating to record degrees of weakness, meaning investors have less and less power to crack down on imprudent activities by companies they lend to.
No wonder that Moody's and the BIS are worried; so am I!
Now you know (better) why I still find it difficult to understand when pundits say EMs have bottomed. From where I stand, they may still have a long way to go (before bottoming).
Let's not also forget that HY isn't only comprised of EM debts. The big chunk of HY is still coming out of developed markets, mainly the US.
The average spread on US HY energy bonds may tell you how extreme things are, even when oil is above $80.
Make no mistake: Record low spreads aren't only characterizing the energy (XLE) sector; it's happening on a much broader scale:
Perhaps this is why Bloomberg wrote that "The Junk Bond Market Looks Like a Runaway Train."
Keep in mind: Over the past few years, oil prices and long/er-term US bond yields have moved in tandem. As oil prices rise to the highest in four years, it's likely for bond yields - especially HY - to follow through.
Last but not least, take a look at the slowing foreign investment in the US. True, this is noisy data, but there are signs we are not talking (solely) about a substantial slowdown but possibly that things are starting to reverse.
As we wrote above: Everything points at only one possible direction for HY bonds. In case this wasn't clear before, the direction (for prices) is down.
Don't board and/or get off the HY, medium-long term duration, runaway train!
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