This junkyard is not a visual metaphor for the high-yield bond market.
Evidently, the high-yield bond bubble started popping last month. And it’s about to take down equity and bond markets alike. At least, that’s the impression we get from the prevailing coverage of a few weeks of junk bond fund net outflows. It’s all a bit bizarre, in our view. It puts way too much emphasis on fund flows and ignores the fundamentals supporting corporate bonds and stocks. A few freaked out investors doesn’t mean a bond bloodbath—or equity bear market—is nigh.
Our stance on high-yield corporate bonds—or junk, if you prefer—hasn’t changed since the last time we discussed this topic. We don’t see evidence of a bubble—not when credit spreads are well within the norm, balance sheets are healthy and a growing economy is reducing default risk. And a few weeks of fund outflows don’t change matters. If you assume outflows mean the bubble is popping, you assume fund flows are a leading market indicator and investors are wonderful market timers.
Neither is true! Look at equity fund flows. They were positive for the first 11 months of the 2000-2002 bear market and in five of the first eight months of the 2007-2009 bear. They were negative for 18 of 19 months from May 2011 through December 2012. They were also in the red from September through December 2009—last we checked, a great time to buy. Bond fund investors are no different. Consider: In late 2010, right about when 60 Minutes featured an analyst’s prediction of a looming tsunami of municipal defaults in a segment with the demure title, “State Budgets: Day of Reckoning,” muni bond fund suffered outflows for seven straight months.[i] But the tsunami turned out to be more of a ripple, and inflows resumed.[ii] No calamity ensued. ETF inflows, too, have turned negative at times during this bull. Stocks kept doing fine. Investors have a long, long history of selling for no fundamentally good reason and subsequently getting whipsawed by a rising market. Or not! The trouble with fund flows is you don’t know where that money is going—another reason not to fret over recent junk fund flows. Extrapolating fund outflows and a bit of volatility into something other than normal, irrational short-term swinging is a pretty big fallacy, if you ask us. (And an odd one for pundits who frequently warn that the slightest equity inflows signal irrational euphoria.)
Even if you buy the fund flows argument, it’s a huge deductive leap from corporate bond trouble to broader market mayhem. Corporate bond markets aren’t a leading indicator for stocks. Nor do they (or should they) perform similarly at all times. Stocks are shares in the earnings of publicly traded firms. Corporate bonds are an IOU from those firms. As you can probably intuit, each asset has different performance drivers. Stocks generally move most (over time) on the gap between reality and expectations for future profitability. Bond prices are mostly influenced by interest rates and default risk. There is some commonality here—balance sheet strength and future growth prospects pay a key role for earnings and creditworthiness—but stocks don’t have a set relationship with interest rates. Rising rates don’t hammer stocks the way they do bonds. Corporate bond markets might be happy if firms boosted balance sheets with new equity offerings, but stocks would frown.
Here, you might be tempted to say, “Yah, but what about the Fed?” After all, most of the stock-bond double trouble jitters stem from the belief the Fed’s assault on long-term interest rates drove folks into “risky” securities like stocks and high-yield bonds in the hunt for better returns. And when the music stops—whether through the end of bond buying or the start of short-term rate hikes—the party ends. But even if you accept the yield chasing argument (which we don’t—see here), there is no evidence high-yield bonds or stocks would suffer. As we explain in much more detail here, here and here, the end of quantitative easing should be great for stocks, and as we show here, rate hikes aren’t an inherent negative. As for corporate bonds, in theory, they should hold up pretty well—credit spreads tend to narrow when rates rise, which means Treasury yields rise more than corporate yields. Which would mean corporates would still be more relatively attractive. Which would mean “yield chasing” could still be a thing, bringing the illogic of this argument full circle.
We won’t argue it’s all roses for fixed income looking ahead. Interest rates look likelier to rise some than fall, and rising rates ding prices. But a bit of volatility and a full-on massacre aren’t the same thing.
[i] Source: Investment Company Institute, Net cash inflows into municipal bonds were negative from November 2010 through May 2011.
[ii] Even calling it a ripple is a stretch.