Diary of a Financier

On credit, in the face of rising rates

In Capital Markets on Thu 22 Aug 2013 at 11:26

Last night, I had to reach out to Josh Brown (The Reformed Broker) after he passed-along a piece by Chris Kimball (Kimball Charting Solutions). Mr. Kimball’s article evaluated the notion of a “Junk Bond Bubble” from a purely technical angle. Specifically, he aimed to address the question of whether or not a junk bond bubble is “about to break,” which he answers [loosely] in the affirmative:

“…junk bond yields are near the lowest in history and have formed a bullish falling wedge, which suggested higher yields should take place and push junk bond prices lower! Lower junk bond prices are often followed by declines in the stock market.” [Emphasis his]

I disagree with the thrust of that notion, so I thought this a good opportunity for me to update my multidisciplinary assessment of credit.

~~~~

I particularly disagree with the “Junk Bond Bubble” meme. The use of “bubble” has an underlying connotation of credit/default risk. My opinion is that systemic defaults are not an imminent risk today. (I’m on the record as saying that I think it’s only around 7th inning of the credit cycle, for a myriad of reasons, and I’m still comfortable with that approximation, considering traditional bank lending is just starting to thaw.)

More importantly, there’s no empirical evidence manifest in capital markets that a bubble has started deflating. For example, we have to look at the recent HYG pullback within context of the broader bond market. HYG has managed to outperform higher quality bond indices like $AGG and $LQD, whether from May’s highs, June’s lows, or July’s double-dip–despite equity (risk) markets hitting the skids over the same period.

In that vein, when evaluating any bonds–high yield included–we must distinguish among the different nodes of interest rate composition that drive bond market pricing:

  1. Risk-free rates
  2. Expected inflation
  3. Default risk
  4. Liquidity
  5. Maturity

Inflation expectations are flat, as 5y5y forward inflation breakevens can attest. Liquidity has waned a bit, but that’s perfectly seasonal and therefore arbitraged-away. Maturity (term-structure) really has no bearing on this conversation, since its only effect on off-the-run bonds is amortized naturally and duration/interest rate effects pertain to other nodes.

That means we’re left to evaluate the risk-free rate and default risk in order to attribute recent credit market movements. Luckily, we can look at spreads between High Yield bonds and equivalent maturity Treasuries to figure out the drivers. Since we’ve already established that the other nodes are controlled, we can accept that HYG is falling due to perceived credit risk if spreads have risen–perhaps indicating the start of a bubble burst. Otherwise, recent price declines are attributable to interest rate dynamics.

This is what I noted (I & II) to Downtown Josh Brown last night. LQD relative spreads¹ (red) have blown-out, while absolute spreads (blue) are generally flat:

Investment Grade credit spreads- absolute, relative & SPX-adjusted

Investment Grade credit spreads- absolute, relative & SPX-adjusted

In contrast, HYG relative spreads have barely ticked wider, and its absolute spreads are also unchanged:

High Yield credit spreads- absolute, relative & SPX-adjusted

High Yield credit spreads- absolute, relative & SPX-adjusted

We already knew this, as I previously mentioned that HYG has outperformed both AGG and LQD. I also mentioned HYG’s resilience in the face of equity weakness, which is manifest in both of the above charts by the credit spread/SPX ratio (green, “SPX-adjusted”). These charts really drive-home the point.

~~~~

I’ve long-tracked the rising wedge development in the High Yield Bond Index ($HYG), as discussed by Mr. Kimball. The pattern has broken-down in accordance with its classical principles. In that regard, I agree with Mr. Kimball that HYG was clearly warning of a pullback.HYG daily/weekly

I disagree that the slide will snowball into a crash here. After all, HYG’s June low found support at a 50% Fibonacci retracement level, a classic drawdown out of a falling wedge that should mark the pattern’s completion.

In fact, for absolute return purposes, I pared our bond exposure in early May–hastened by that rising wedge and relative value. To wit, I talked fundamentals with a bank loan portfolio manager in the beginning of June, and here are my notes:

His underlying assets reached an average price of $101.44; because supply is getting thin with spreads tight, he had to wade into the High Yield market, accumulating a 12% allocation to junk bonds. Maintenance covenants starting to be compromised, but collateral still 1.5-2.0x coverage. Regarding credit cycle, he’s “seeing opportunities but it’s getting challenging,” with default rate still low (1.4% ttm v 5% historical); expected defaults to rise into YE13 due to 2007 vintage deals that’re slowly falling apart (i.e. First Data/TXU/ClearChannel).

BKLN’s weighted average price is back down below par to $98.74–right where these assets should trade on a historical basis, due to embedded, perpetual call options.

For relative return purposes, I have maintained a lowly 28% allocation to bonds vs 40% benchmark, almost all of which is in Short Term HY ETF ($SJNK), Floating Rate Senior Bank Loans ($BKLN), and non-agency MBS. (We own only 2 singlename bonds, which are both event driven opportunities.) No accident that our fixed income holdings are entirely low duration and have been for almost 2 years now.

~~~~

Mr. Kimball may not have intended to illicit this response, but as I said, the use of “bubble” warrants more material defense. His technical analysis just doesn’t equate with the magnanimous implication that a bubble bust is neigh. Further, his focus on “Junk Bonds” suggests the “break” is unique to that asset style, as opposed to the whole fixed income class.

I wanted to crack-down on this sort of loose prophecy, because a lot of pundits have proffered similar, soft predictions in the last 5 years. One of them will get it right one of these days too. (Is there a joke about a broken clock, a blind squirrel, and an economist calling 5 of the last 2 recessions?)

I agree that the Fed’s interventions have distorted capital markets, and I agree that the effect of such distortions will be manifest in the long term. If that’s your rub, complain about regulators’ policy and market disruptions. If you’re calling for a bubble–which purports something of a crash–give me a reason, catalyst, timing, and/or price.

I can say that a recession is coming; I can ascribe 100% confidence to my recession call too, and I’ll be 100% correct… as long as I don’t have to get into specifics. What value is that to anyone? So, if you see a crisis coming, why are High Yield bonds in a bubble that’s going to pop in the short term? I myself cannot find sufficient evidence to say it’ll happen here & now.

–Romeo

¹As I’ve mentioned before, I prefer using relative credit spreads, as opposed to absolute. If you look at the math (and consider today’s low interest rates), it’s obvious why relative spreads are a more significant indicator.

Advertisements
  1. […] the higher prices you find.   IG corporate credit spreads have widened a bit; High Yield’s have not; and the equity market has coiled its way to alltime highs with its risk premium […]

Comment

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s