High Yield – Pricing in a Recession, Liquidity Crunch, or Both?

Posted by on Oct 1, 2011 in Uncategorized | No Comments

The key macro driver this week has been the plan to plan a “Grand Plan”.  While the market has been focused on this big headline grabbing news, something is happening in the High Yield market that is worth watching.  The bottom end of the market is falling apart and this is during a period of retail inflows.

High Yield – Retail Buying, Professional Selling

HYG has been selling off this week.  It is down 1% since last Friday.  In the meantime, the S&P is up about 2%.  So it is interesting that High Yield has underperformed by 3%.  5 year treasuries are barely down on the week, so it can’t be rates, and the high yield market doesn’t track rates that closely anyways.

My first reaction was that there must be some pretty significant outflows.   But that is just not the case.  HYG and JNK both had increases in shares outstanding.  EPFR fund flows were positive $423 million this past week.  This strikes me as very odd.  High Yield price action usually tracks fund flows pretty well.

Source: Bloomberg

The above graph, while not great, shows that outflows typically accompany market sell-offs.  The move this week is highly unusual.  A big sell off in the market, but signs that retail is putting money into junk bonds.  That can only lead me to the conclusion that institutions and banks are pulling back from the market.  They are either worried about the potential for a recession or need to raise cash, or both.  The same thing is occurring in the investment grade space where LQD is declining, spreads are widening, yet shares outstanding increased.  This reminds me of the fall of 2007 when dealers were shedding all inventory because they were afraid of any risk and they were having funding issues.  In investment grade, the basis went from pick 15 to pick 35.  Some thought it was  great opportunity to buy bonds and buy CDS.  It turned out the funding pressure was persistent and that basis continued to get wider, peaking at over 100 after Lehman a year later.  There isn’t the exact same feeling as 2007, but this divergence between what retail is doing and what institutions seem to be doing needs to be watched very carefully.  It may not be as exciting as “Grand Plans” but in the end it may be more important and a better indicator of stress in the US financial system.

The CDX Index is trading cheap, but the ETF’s are trading rich to an already overstated NAV

There is another bizarre thing going on in the markets.  HY17, the CDX index is trading over 1 point cheap to fair value.  That implies that institutions are eager to hedge their exposure.  They are shorting something more than a point below where it should be trading in theory.  That isn’t very uncommon, but is a reliable indicator that liquidity in the cash market is non-existent.   What is particularly strange is that HYG is trading above its NAV.  So retail investors are willing to pay more for HYG than it is worth, and the NAV is probably overstated as there is always a lag during market sell-offs.  Either the professionals or the amateurs are wrong here.  Since retail investors tend to invest solely on the theory that the yield is good, I suspect they will be the ones to lose here.  They are overpaying to invest in an asset class that the real market is paying a penalty to exit.

The weakest credits are getting hit the hardest

The equity market may be debating whether or not the economy is headed for a recession, but the high yield market seems to have decided it is better to be prudent and is shedding risk.  These returns from the Merrill Lynch High Yield index show that the CCC component is getting hit the worst.

The subcomponent returns are a clear sign that de-risking is occurring.  This makes me particularly concerned about what the ETF’s own.  There is a negative selection bias that as dealers “create” new shares, they deliver portfolios of bonds.  Retail is busy buying ETF’s and dealers are getting jammed on bonds.  You have to assume that dealers are delivering portfolios of the hardest to sell bonds to the ETF’s.  These are the bonds that are quoted and marked the furthest from actual clearing level prices.  This could be a big problem for the ETF’s.

Even the ML index understates how bad the performance of CCC bonds has been.  The index typically uses a mid market price for its calculations and will often rely on quotations rather than actual transactions.  As bid/offer spreads increase, the “mid” market price is further away from true clearing levels.  The quotations also tend to be on the high side as the dealers aren’t really making live bids, but would be happy to get lifted as they now they can find sellers of bonds if they can find a buyer willing to pay yesterday’s price.  This could easily overstate the market for “index” and “NAV” purposes by several points.  I pulled up 3 most active HY bonds according to TRACE yesterday.  The HCA recent new issue, which I wrote about yesterday, did reasonably well compared to the marked, but pretty poorly for a new issue where the dealers should have a nice short covering bid.  The other two bonds show the depth of the problem in the high yield cash market, a problem that has been largely ignored.

The “blue” bond is First Data corp 10.55% rated  Caa1/B-.  The “white” bond is Hovnanian 10.625% B2/CCC.  The round lot closing price for HOV was actually 79, so not quite as bad as the small trade that occurred at 77.5, but stil pretty bad performance.  Although the housing data yesterday was enough to let the HOV stock trade up marginally, the bond market did not care.  For a company with a market cap of only $150 million, I would pay more attention to what bond investors are saying about the prospects, than the equity market.

The high yield bond market is in worse shape than most people realize.  HYG looks extremely rich relative to what is going on beneath the surface, and this liquidation is occurring into quarter end, when bond investors have just as much incentive to “window dress” as stock investors do.  And it isn’t just domestic high yield.  Emerging Markets, and Asian Property companies in particular, are seeing their bonds getting crushed.  It may be more fun to watch the EU contort itself and find some way to lend money to itself that makes the markets happy, but in the depths of the credit world, there is a problem, and it is getting worse.