FLASH UPDATE: Spread Risk, Duration Risk, Price Risk and Credit Default Risk

Spread Risk, Duration Risk, Price Risk and Credit Default Risk

Are those enough risks for you?  As we continue to try to better understand the inter-connectivity of the macro and micro economy, similar themes persist.  Bubbles are inflating in junk bond issuance, credit quality and yields.  As the risks in the high yield market continue to inflate and metastasize, potential returns in the space have become laughable.  According to John Phelan, a fellow at the Cobden Centre, “…the Federal Reserve has become an enabler of the financial havoc it was designed to prevent.”  This, of course, has been well-documented and discussed by Tradex over the years.  The problem with euphoric markets (ie. the current fully heated high yield credit market) is that no one wants to exit until they are sure everyone is leaving.  Naturally, we know in hindsight, that it is typically too late to sneak out the tiny door at that point. 

This morning a Bloomberg article was printed citing well-known hedge fund operator Marathon Asset Management as saying, “We hate high yield…” and …”It’s trading at dangerous levels.”  Spreads between high yield bonds and investment grade have recently hit all-time record tights.  Concerns about duration exposure in bond portfolios has been downplayed for the time being, but if interest rates rise – bond prices could fall significantly.  As a rule of thumb, a bond with a duration of 10 years would experience a price decline of 10% in the event that interest rates rise 1%.  The number of corporate defaults is well below average currently, and well-known high yield gurus and hedge fund operators are starting to ramp up their default expectations.  Historically, 45% of CCC-rated issues default cumulatively four years after issuance.  Danger lies ahead…

The forgetful survivors of the last credit bubble pledged that they’d be more careful, less greedy and less-short-term oriented.  We haven't forgotten the fear and pain that was enigmatic of most days in 2008.  When we look at the bottom tier of the high yield market, we recognize that leverage has risen again, stricter lending policies have not been heeded and balance sheets are fragile.  The sub-investment grade universe has seen record bond issuance, and unsustainable low default rates.  Someday rising bond markets will no longer be government policy, and QE will end.  At some point, corporate failure will be allowed again.  Someday, interest rates will be higher, bond prices will be lower and owning fixed income may be more attractive.  Yesterday, betwixt and between continued "Taper" talk, Fed Chairwoman Janet Yellen suggested that the first rate hike may come sooner than the market expected.  As we have playfully illustrated in the past, when the music stops, finding an empty seat is harder than it looks.  Today, we think being short high yield is the only way to be involved in (and a survivor of) the risky corporate credit market.

Richard Travia
Director of Research