Seeking Alpha readers are going to get two high yield corporate bond market articles for the price of one this week. When that price is free, that is an even better deal! In this first article, I will describe how the typical Santa Claus rally in high yield corporate bonds went awry in December. After a fairly remarkable two months for the junk bond market, the second article will then discuss the current outlook for this segment of the market.
In late November, I wrote a piece entitled The Santa Claus Junk Bond Rally. Those two months - December and January - tend to be very strong periods for the high yield bond market as seen in the table below. December and January produce the best risk-adjusted monthly returns and are most likely to produce positive returns over a three decade-plus market history.
*Returns from July 1983 - November 2018
This calendar effect is one of my favorite market anomalies, and has meaningful implications for Seeking Alpha's fixed income investors. Since the advent of the modern high-yield debt market in the early 1980s, there has been a bankable calendar trade that has persisted. In the previous table, readers can see that the highest total returns in the high-yield market have historically been experienced in January (1.82%). December is not far behind at 1.18%. The two months have produced the best risk-adjusted returns and have been the most likely months to produce positive total returns at 86% and 83% of the time respectively. These two months, which make up one-sixth of the calendar year, have historically generated just over one-third of the returns of the high-yield bond market.
A large part of this market anomaly is likely driven by the holiday-influenced lack of primary issuance in this dealer-driven market. Unlike equity markets, which will produce only several dozen domestic IPOs in even the most bullish of years, multiple, new high-yield bond issues will come to market each day when credit investors are receptive. Credit markets will slow down around the Christmas holiday and early in the New Year. When lower supply meets still healthy demand, prices typically rise.
In December 2018, we certainly saw a lack of issuance. In fact, the market dislocation in December led to the first month with no new issuance since November 2008 in the aftermath of the Lehman Brothers bankruptcy and amidst the worst credit markets in a generation. In December, the high yield corporate bond market produced its worst monthly return (-2.14%) since the bear market for commodity-sensitive credits in late 2015. The two largest high yield corporate bond exchange-traded funds - the iShares iBoxx High Yield Corporate Bond ETF (HYG) and the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) also produced their worst monthly retunrs in three years.
If a dearth of primary issuance tends to lead to higher returns, then what happened in December 2018? In a dislocated market with no new issuance, there was little to no price discovery and bonds gapped lower. As the short-term credit market freeze lifted in early January, primary issuance recovered. As sentiment improved, bond prices rallied further. New supply did not overwhelm demand from investors emboldened by the possibility of a "Fed pause". January 2019 high yield corporate bond returns (+4.52%) were the best monthly return since October 2011 when bond markets rebounded from the U.S. debt downgrade and European credit stress-related sell-off.
It was a bumpy two months for high yield corporate bonds, but those who held through the ride earned 2.3% returns for the two-month period. With the Bloomberg Barclays High Yield Index yielding 6.89%, this one-sixth of the year probably is going to translate into one-third of annualized returns (even assuming an unlikely zero default losses). Santa Claus may have been a bit late to the party, but by the end of January, junk bonds had delivered their typically outsized seasonally strong performance. In a related article, I will discuss where that currently leaves the high yield corporate bond market for Seeking Alpha readers.
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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.