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Record low junk bond yields a warning sign for stocks

Tadhg Gaelach

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(Reuters) - Calling the top in world markets and getting the timing of it right seems like a lottery, but predicting the catalyst for the turnaround may be less random.

High-yield, or so-called “junk”, bonds are on a tear that puts even record-busting stock markets in the shade. Last week, the yield on the Merrill Lynch global high-yield bond index fell below 5 percent for the first time ever. The European index yields barely 2 percent.

To put that into context, European junk bonds yield less than 10-year U.S. Treasuries trading around 2.35 percent.


If there’s evidence of irrational exuberance anywhere in financial markets, this may be it. And if that’s the case, this will be where the first tremors of a broader market earthquake will likely be felt.

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COLUMN-Record low junk bond yields a warning sign for stocks: McGeever
 
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Tadhg Gaelach

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Falling junk bond spreads trigger sense of foreboding

Lack of investor protections and effect of central bank stimulus cause rising concern

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Oleg Melentyev, Bank of America Merrill Lynch’s new head of high-yield strategy, has been dogged by a question from clients over the past month: what is to stop the extra yield investors demand to own the riskiest corporate debt falling to a record low? It’s an issue animating the $1.3tn US junk bond market as the premium that investors want over US government bonds — or spread — has fallen by almost a fifth this year and is nearing the tightest level since the financial crisis. Accompanied by a rally in US stocks to record peaks, the drop has also seen a refinancing boom in which companies have sharply cut their borrowing costs. Mr Melentyev’s short answer is that “it will just take time”. “This is an illiquid asset class and repricings . . . don’t happen overnight. They happen gradually if ripe conditions exist long enough,” he says. It is a conviction strengthened after the European Central Bank last week extended its bond-buying plan into much of 2018, while the Bank of Japan this week showed no wavering from its easing programme. Together, they are propelling investors from Europe and Asia into US markets. The view that spreads could tighten to record lows is shared by others on Wall Street even as fears grow over the risks. The spread on junk bonds reached 338 basis points earlier this month, just 3bp above a 2014 nadir that remains the lowest since the financial crisis. The all-time low remains 241bp, set in 2007. The asset class has been a winner for investors, generating a total return of 7.4 per cent this year and outperforming investment-grade bonds, according to ICE BofA indices. Leveraged loans have gained just under 3 per cent, data from S&P Dow Jones Indices shows. S&P Global and Fitch rating agencies project defaults will decline over the coming year. Fitch analysts say the default rate of high-yield corporate bonds could slide to 2 per cent by the end of 2018, its lowest level since 2013. “Spreads should be tight, yields should be low,” says Michael Buchanan, deputy chief investment officer of Western Asset Management. “The fundamental backdrop should be supportive for credit and we don’t see that changing anytime soon. Look at defaults. They are improving and heading back to post-crisis lows.” But Western Asset is among a number of investors, including BlackRock, DoubleLine Capital and JPMorgan Asset Management, which have reduced their holdings in high-yield bonds, which Mr Buchanan says reflects lofty valuations. The risks that come with the rally are multiple. Some investors are worried that bond buying from the ECB and BoJ has distorted corporate credit markets. At the same time, investor protections, which take the form of covenants and can restrict the level of indebtedness a company can take on, have been whittled away. “It is very clear that financial conditions in the world are too easy,” says Rick Rieder, BlackRock’s chief investment officer of global fixed income. “The ECB is continuing to buy credit assets. The [yields] levels are not sustainable over the long term, but in the interim it also influences the flow of demand into US assets.” Despite the hesitancy of money managers to pour more money into the asset class, a dearth of new supply is also keeping the pressure on the spread with government bonds tight. At $221bn, high-yield corporate bond issuance in the US so far in 2017 remains below its average of the past five years, according to Dealogic. Strategists at Wells Fargo note that the asset class will be buoyed by inflows of nearly $25bn over the next five weeks through a mix of coupon payments as well as called and tendered bonds. It is money that is likely to be ploughed back into the market. “Right now we are in an issuer-friendly environment given the supply demand dynamics as it relates to covenants and terms,” adds Gerry Murray, the head of North American leveraged finance for JPMorgan. The lack of high-yield supply is also down to the loan market, where companies have increasingly turned for funding. Looser constraints on borrowers in the loan market have provided an incentive for companies to tap the money flowing into loan funds. Roughly $18bn has flowed into leveraged loan funds this year, according to EPFR, although the vast majority was added between January and June. “People are throwing so much money into the loan market,” says Gershon Distenfeld, director of credit at AllianceBernstein. “People throw money at that market and allow issuers to refinance at lower spreads. It is going to end up being a mistake.” For Mr Melentyev at BofA, the decline in spreads to near post-crisis lows is somewhat foreboding. Excess returns — or the gain above the return on a risk-free investment — are typically negative in the three to five years after spreads approach or fall below 300bp, he notes. And then there is the simmering worry over how badly the erosion of covenants will hit bondholders when companies do run into trouble and creditors fight for a share of the assets. “The absence of covenants reflects the relative strength of issuers at the negotiating table,” Mr Melentyev says. “The longer-term question — whether eventually we’ll find out this was a mistake and default rates will be higher — it is hard to say. We’ll have to live through it to figure it out.” eric.platt@ft.com Twitter: @ericgplatt
 
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Tadhg Gaelach

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#3
High-Yield Spreads Are Too Thin Vis-a-Vis Default Risk and Business Activity

Industrial commodity price deflation increases high-yield default risk and vice versa.

Feb 16, 2018

The market value of U.S. common stock has rebounded by 5.8% from February 8’s bottom, but remains 4.8% under its record high of January. A corporate bond rally that began on Wednesday continued today. On Thursday, a composite speculative-grade bond yield sank by 12 basis points to 6.34%, which narrowed the high-yield bond spread to 366 bp.

Nevertheless, from the perspectives of the U.S.’ actual and projected high-yield default rates, as well as the recent average and median expected default frequency metrics of U.S./Canadian high-yield issuers, the credit quality of U.S. corporations has yet to return to its highs of the current recovery, which it reached in 2014. For example the high yield default rate is projected to slide from January’s 3.2% to 2.0% by January 2019, and the latter would still top September 2014’s low of 1.62% for the current upturn. Moreover, the default rate’s moving 12-month average of the current recovery troughed at the 1.81% of the span ended May 2015, or just prior an outbreak of severe industrial commodity price deflation.

The yearly percentage-point change for the EDF measure of high-yield default risk shows inverse correlations of -0.73 with the annual percent change of Moody’s industrial metals price index and -0.39 with the annual percent change by the price of WTI crude oil. In other words, industrial commodity price deflation increases high-yield default risk and vice versa.

According to an explanatory model showing a very meaningful adjusted r-square statistic of 0.89, the high-yield bond spread now appears to be too thin both with and excluding the now-elevated VIX index. Using various lags, the model explains the high-yield bond spread in terms of (i) the average expected default frequency metric of U.S./Canadian high-yield issuers, (ii) the VIX index, and (iii) the moving three-month average of the Chicago Fed’s national activity index. When including the recent VIX index of 19.8 points, the model recently predicted a 460 bp midpoint for the high-yield bond spread, which was much wider than Thursday’s 366 bp.

After removing the VIX index from the set of explanatory variables, the adjusted r-square eases somewhat to a still-respectable 0.84. Despite the removal of a now above-trend VIX index, the remaining explanatory variables predict a midpoint of 424 bp for the high-yield spread that still exceeds the actual spread.

Thus, barring significantly lower readings for the high-yield EDF metric and the VIX index, as well as a jump by the national activity index, the high-yield bond spread is more likely to widen than narrow. By the way, the recent high-yield EDF metric of 3.53% compares unfavorably with its yearlong 2014 average of 2.31%.

Given the recent intense focus on the effect of labor market conditions on price inflation, it’s worthwhile to examine the historical correlations of the several variables in the news, namely the 10-year Treasury yield and the annual rate of personal consumption expenditure price index inflation with and excluding food and energy prices. For a sample that begins in July 1985, the 10-year Treasury yield shows its strongest correlations with the percentage of the workforce at least 55 years old (-0.87,) the annual rate of core PCE price index inflation (0.79), the percentage of industrial capacity in use (0.65), the labor force participation rate (0.64), PCE price index inflation (0.63), and the year-to-year change of the labor force participation rate (0.57).

Though the growth of the average hourly wage shows a meaningful correlation of 0.45 with the 10-year Treasury yield, it still falls well behind the previously mentioned indicators. One surprise might be the 10-year Treasury yield’s comparatively weak correlation of -0.16 with the unemployment rate, especially relative to the Treasury yield’s 0.65 correlation with the percentage of industrial capacity in use.

The annual rate of PCE price index inflation shows its strongest correlation of 0.52 with the percentage of industrial capacity in use (or the capacity utilization rate), followed by correlations of 0.46 with the annual percentage change by the price of West Texas Intermediate crude oil, and -0.43 with the percentage of household-survey employment for those at least 55 years old. PCE price index inflation’s other notable correlations are 0.37 with the yearly change of the labor force participation rate, 0.35 with the yearly change of the capacity utilization rate, and 0.32 with the labor force participation rate.

The much-cited yearly change of the average hourly wage reveals an uninspiring correlation of 0.25 with PCE price index inflation. Finally, the unemployment rate and its year-to-year change generated correlations of -0.12 and -0.16, respectively, with the annual rate of PCE price index inflation.

Relative to core PCE price index inflation, the unemployment rate and its year-to-year change revealed meaningless correlations of -0.02 and -0.06, respectively. In stark contrast, the yearly percentage-point change of the labor force participation rate revealed a noteworthy correlation of 0.52 with the annual rate of core PCE price index inflation.

And, once again, the percentage of household-survey employment at least 55 years old reveals a substantial inverse correlation of -0.52 with the annual rate of core PCE price index inflation. The capacity utilization rate’s 0.48 correlation with the annual rate of core PCE price index inflation easily doubled average hourly earnings’ 0.21 correlation with inflation’s underlying pace.

High-Yield Spreads Are Too Thin Vis-a-Vis Default Risk and Business Activity | Moody's Analytics Economy.com
 
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Tadhg Gaelach

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#4
VIX Soars and High-Yield Bond Issuance Plummets

Fears of a deep and extended slide by equity prices have surfaced

Feb 20, 2018

If the U.S. economy is so hot, then why did the share price of Walmart, one of the nation’s biggest retailers, plummet by 10.18% on Tuesday? Despite this noteworthy hint of a wary U.S. consumer, a heavy supply of new short-term U.S. Treasury debt pushed the 10-year Treasury yield up to 2.89% at close.

The PHLX index of housing-sector share prices responded to the subdued guidance from the retailing giant and higher benchmark Treasury yields with a 1.2% plunge on Tuesday. Inflation fears may have been allayed somewhat by the announcement of broadly distributed price cuts from another retailing powerhouse.

February’s financial market volatility slashed U.S.-dollar-denominated high-yield bond issuance by 50% year over year from February 1-13. By contrast, U.S.-dollar-denominated investment-grade bond issuance managed to rise by 2% annually, according to the same serial comparison. February’s year-over-year nosedive by high-yield bond offerings can be partly ascribed to a surge by the VIX index from its 11.3-point average of February 1-13, 2017, to the 26.5-point average of February 1-13, 2018.

In addition, though the average high-yield bond spread narrowed from 395 basis points to 363 of those two periods, respectively, the accompanying average of the composite speculative-grade bond yield rose from 5.89% to 6.2%, respectively. Even for high-yield, changes in the average corporate bond yield offer better insight regarding changes in corporate bond issuance than do changes in average corporate bond yield spreads.

As an offshoot of recent equity market volatility, fears of a deep and extended slide by share prices have surfaced. Nevertheless, the still-positive outlook for corporate credit quality contradicts such worries.

In a manner that is consistent with the blue-chip consensus’ anticipated acceleration by the pretax operating profits of U.S. corporations from 2017’s likely 4.5% yearly increase to 2018’s expected 6.3%, Moody’s Default Research Group recently projected a drop by the U.S. high-yield default rate from January’s 3.2% to 2% by January 2019.

The record since 1983 shows that 84.5% of the year-to-year declines by the default rate were joined by a year-to-year increase for the market value of U.S. common stock. The exceptions were mostly associated with the temporary interest rate spikes of 1984, 1987, 1988 and 1994. The other exceptions occurred during 2002-2003’s bout of market anxiety stemming from the collapses of Enron and WorldCom. For each of these exceptions, the equity market sank despite either an improved or strong showing by profits. More specifically, the six previously mentioned years showed a 17% average annual advance by pretax operating profits. Not only can markets be irrationally exuberant, they also can be unduly risk-averse.

VIX Soars and High-Yield Bond Issuance Plummets | Moody's Analytics Economy.com