Over
the last few years, candidates for being the harbinger to the end of this bull
market have come and go. We’ve had the Grexit crisis, China collapse, tech 2.0
bubble, property bubble, and much more that have growled, only for the market
to yawn and keep rallying. But over the last month, a more interesting
candidate has surfaced, which has been overshadowed by the scare about a China
collapse: high yield bonds, formerly known as junk bonds.
In mid-December,
2 high yield funds halted redemptions to avoid liquidating assets in a fire
sale: Third Avenue’s $3bn Focused Credit Fund and Stone Lion’s high yield fund.
In other words, there simply is not enough liquidity in the high yield space to
meet any type of selling. Illiquidity in the bond market has been well flagged
this year; if even the IMF warns about this (in Sep 2015), you can be sure
everyone knows. While the market has more or less shrugged this incident off,
it’s a warning shot to risk assets. There’s no need to panic just yet, but it’s
become clear where the risk is.
The underlying
cause for all of this undoubtedly is low interest rates and leverage. The risk
curve shifted down and money went to all types of yield seeking assets,
including property, dividend stocks, higher yielding currencies (ie emerging
markets), and of course high yield bonds. Other examples of an outcome of
ultra-low interest rates are unprofitable ‘unicorns’ as well as companies
issuing debt for share buybacks. Simple reversal means money flows the opposite
way. For assets which are leveraged, like
REITs, high yield bonds, problems become magnified. Today one of the issues
is energy prices collapsing from >$100 to <$40 in over 1 year, dragging
down the high yield market where it is ~14% of the market. While energy high
yield bonds itself may not bring down the entire market, increasing rates over
the next year or two will undoubtedly cause problems for the high yield market.
While pundits
continue to worry about the slowdown in growth in the USA, they really don’t
need to with unemployment close to NAIRU and wage growth picking up. Walmart is
a key example where they have raised minimum wage to $9 and then will further
raise to $10 by February 2016. They didn’t necessarily want to, but they needed to with labor market competition
increasing. While costs will rise for companies, ‘main street’ will benefit and
start spending their excess savings. Add that onto savings from lower gasoline
prices, the USA will be doing just fine. For now, they are dragged lower by big
oil cutting spending, but in the longer run the rest of the economy will
benefit, starting from the consumer.
Which brings me
to my final topic of discussion, the Fed’s pace of tightening. For the next
year, the dot plot projects 4 rate hikes, which is exactly what the overall
market is currently factoring in. Last I checked 10 year treasuries are trading
at ~2%, which means market isn’t factoring in much of inflation at all. This is
a huge risk for the market with labor markets tightening and wage inflation
creeping up, as it could imply rate hikes quicker than market expects. You can
be sure the market will not like that.
For the near
future though, the market continues to choose to ignore these warning signs and
misplaces their fears. The market is nervous, but not about the structural
issues such as an overinflated high yield market and higher inflation.
They’re still worried about things like China, ISIS, OPEC, crude oil, things
that make the headlines but not the ones that will bring down the market. The
market will continue to climb the wall of worry, until it finally faces the
problem children of zero interest rates - and you can be sure high yield bonds
will be one of them.
