Pete Michel
Into Perspective

About That High Yield Selloff

By, 11/17/2017
Ratings614.065574

Editors’ note: MarketMinder does not recommend individual securities. The below simply represent a broader theme we wish to highlight.

Is it over for high-yield bonds? Is their selloff the canary in the coalmine for stocks? These questions preoccupied investors as high-yield bonds fell in recent days, reminding some of early 2016’s weakness. However, like that selloff, this one is mostly concentrated in one sector. Moreover, the move in high-yield spreads is in line with other small moves we’ve seen in the recent past, and the high-yield market appears to be functioning fine despite liquidity concerns. And as always, bond and stock markets are similarly liquid and price in widely known information simultaneously. One can’t be a canary in the coalmine for the other. Markets are too efficient.

While January 2016’s high-yield selloff was centered in the Energy sector, this one is largely concentrated in Telecom, which accounts for about 10% of the high-yield market by par value. While triggers are always difficult (and usually impossible) to pinpoint, this one began as the T-Mobile and Sprint merger fell apart. Both companies are big junk bond issuers with sizable maturities coming due in the next few years. Weak Q3 earnings from other Telecom firms also contributed to the weakness. The Senate’s proposal to delay the corporate tax cut until 2019 may also have contributed, as well as a general realization by investors a tax bill won’t be as easy to pass as some presumed—potentially impacting future debt issuance. All those factors plus more likely contribute to a sudden slight souring of sentiment, hitting high yields.

To see this, look at option-adjusted spreads (OAS). Now, that’s a lot of financial lingo, so let me break the terminology down first. A spread, simply, is the difference in yield between two bonds of equivalent maturities. Most of the time, folks look to these to measure the market’s perception of risk by comparing an issuer’s yields to high-quality sovereign bond yields. This allows you to factor out a general increase in yields and see the premium investors demand for taking on more risk. The option-adjusted part refers to call and put features. A call feature allows the issuer to redeem a bond before maturity but after a certain date; a put feature allows the bondholder to do the same. These features can affect a bond’s maturity; the OAS calculation equalizes them to facilitate fair comparison. (You can get these free online here.)

With that out of the way, consider: Immediately before the selloff, option-adjusted high-yield spreads reached a post-financial crisis low. Numerous articles hit the financial press about the top of the high-yield market—classic fear of heights.

The correlation between high-yield bonds and stocks (especially smaller, US-based companies) is well known, and with the recent selloff there were a number of articles suggesting it is a warning about the end of the equity bull market. However, this seems overwrought. Exhibit 1 shows the option-adjusted spread for the ICE BofA ML High-Yield Master Index (versus Treasurys, in basis points—hundredths of one percent).[i] Since the last stock market correction ended in February 2016, high-yield spreads have had five larger spikes in absolute terms. In relative terms, the last four spread increases were larger than the recent spike. Exhibit 2 shows high-yield spreads over the longer term—the recent move is almost too small to see.

Exhibit 1: High-Yield Spreads Since 12/31/2015

Source: FactSet, as of 11/13/2017. ICE BofA ML High-Yield Master and High-Yield Telecom Option-Adjusted Spreads, 12/31/2015 – 11/10/2017.

Exhibit 2: High Yield Spreads Since 1/1/2003

Source: FactSet, as of 11/13/2017. ICE BofA ML Option-Adjusted Spread, 12/31/2002 – 11/10/2017.

Also important to note, once again liquidity in high-yield markets hasn’t been a problem during the selloff. While many have feared regulations and the growth of ETFs would harm bond market liquidity, the opposite has proven true: ETFs continue aiding overall liquidity by helping facilitate trades without bonds actually being bought or sold. For example, based on data from Bloomberg and State Street, as spreads reached a two-month high last Thursday, the five largest high-yield ETFs saw $5.13 billion of traded value, with near record volume (four times the three-month average). Despite this spike in trading, these ETFs only had a net outflow of $378 million.

In my view, this looks like another short term selloff and not the end of high-yield outperformance. The same factors leading us to believe US stocks should do well (even if they don’t outperform globally) should support high-yield markets—namely, continued economic growth, political gridlock and warming sentiment.

 

[i] Intercontinental Exchange (ICE) recently purchased Bank of America Merrill Lynch’s (BofA ML’s) index business, which BofA acquired when it bought Merrill Lynch back in 2008.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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