From Tulips to Tech to Housing – Why the Musical Chairs Game in the High-Yield Bond Market Will End Badly

The Tradex Group – White Paper Series

May 13, 2013

By Richard Travia, Director of Research

From Tulips to Tech to Housing –

Why the Musical Chairs Game in the High-Yield Bond Market Will End Badly

Bubbles beget bursts…It’s a simple fact of investing that has proven true time and again, from the Dutch tulip mania in the 1800’s to the US dot-com burst in 2000 to the US housing market frenzy and crash to the most recent plunge in the price of gold.

For close to four years though, the investing world, ourselves included, has been waiting for what many perceive as the ultimate bubble to burst; the bond market bubble, which has been inflated to a size never before seen, thanks to record low interest rates and unprecedented amounts of stimulus that have pushed yields to historical lows – and pushed investors to funnel billions into risky corporate debt securities.

Indeed, with very little money to be made on government bond yields, investors for the better part of the past two years have increasingly been shuffling their way down the food chain into higher-yielding notes and riskier debt instruments that offer more attractive coupons, higher overall returns, but a tremendous amount of principal risk.  The results have been nothing short of spectacular:  with the total returns of high-yield offerings having matched those of the S&P 500, but with much lower price volatility.

High-yield performance relative to the benchmark Treasury index is mostly dictated by two rather obvious factors:  monetary policy and the underlying health of the corporate sector.  High-yield bonds tend to outperform the Treasury market when the Federal Reserve is easing and when credit quality is improving.  Conversely, the combination of tighter money and deteriorating corporate health are common factors in every major bear market since the inception of the high-yield market.

At this stage of the game, speculative-grade securities appear to be nearing an extreme.  According to economic research firm Bank Credit Analyst, the average price of a bond in the high-yield index is well above par, at $105.92.  “It will be difficult for prices to rise much further given that roughly 70% of public market high-yield bonds include some type of call option to the benefit of the issuer,” BCA notes.  “Thus, total return investors who have become accustomed to equity-like returns from high-yield bonds are liable to be disappointed buying at these prices.”

In other words, there are no more seats to be added to the game of musical chairs being played out in the debt markets.

There is a possibility that high-yield securities as a whole have further to run though.  Monetary authorities have vowed to maintain an aggressive policy stance in support of economic recovery, which will continue to support corporate cash flows, keep default rates from rising and perpetuate the ongoing credit-agnostic search for income in a yield-starved investment climate.

The Fed, in particular, has made clear that it will continue with its bond-buying program, leaving its hand off the turntable needle by artificially suppressing the Treasury yield curve and keeping a firm grip on supply.  This means investors will continue their unabated hunt for higher-yielding assets, increasingly allocating to more-risky types of debt instruments based on their assessment that the music isn’t ever going to stop.

By BCA’s assessment, high-yield spreads could well continue to grind tighter on a multi-year investment horizon, perhaps eventually approaching the previous lows achieved in 2005-2007.

For us, it’s not as much about the timing as the ugly, damaging, bubble-busting maelstrom that will hit when the Fed does finally yank up the record player needle.  The scramble for chairs will be ugly.  Not only will the mad dash to unload anything debt related be massive, but the additional consequences of rising corporate default rates will exacerbate the panic as investors rush to find a chair in game where they will all have been taken away.  In the meantime, there are hundreds of vulnerable companies that are highly levered and cannot afford a secular, cyclical or idiosyncratic bump in the road. 

From a longer-term perspective, the expected returns for the S&P 500 should be around 6-6.5%, with 4-4.5% nominal GDP growth and 2% dividend yields.  The expected total returns for high yields stands at around 8.8%, according to BCA.  Even taking into consideration corporate default risk, expected returns in high yield still exceed common shares.

But it’s the amount of money flowing into ever-risker types of junk that commands the most attention.  As of March 2013, yields on a record 38% of the $1.1 trillion of notes sold by the neediest US borrowers were trading below the 10-year average rate for investment-grade debentures last month, according to data compiled by Barclays Plc.

So how to play a game that everyone knows is going to end, and end badly?  At the moment, sentiment appears to be turning against both high grade and speculative grade US corporate bonds.  Short interest on junk bond ETFs has reached new cyclical highs and negative stories appear in the financial press on almost a daily basis.  The prop desks and dealers are no longer there to provide liquidity, as increased regulation has all but eliminated these traders. 

Yet the music is still playing.

The bottom line is that in their quest for yield, investors are getting less and less compensation for taking on more and more risk.  Investment memories can be very short.  And as the high yield party rocks on, and as the volume of the music screeches louder, the bubble continues to grow as does its weakness.

Even if the Fed can orchestrate a way to rein in its stimulus efforts that doesn’t prompt a panic, an unexpected announcement by Fed Chairman Ben Bernanke, the European Central Bank or even the Bank of Japan could be the pin to prick the bubble.  And it will be a massive bubble.

Richard Travia serves as Director of Research of Tradex Global Advisors.  He is a Partner and co-founder of the firm, and he focuses on hedge fund manager due diligence and selection while also overseeing the R&D for Tradex’s systematic hedge fund identification models.  Headquartered in Greenwich, CT, and managed by partners Michael Beattie and Richard Travia, Tradex Global Advisors was launched in 2004 and today manages a single hedge fund and several fund of hedge fund portfolios.  Learn more about Tradex at http://www.thetradexgroup.com or follow Tradex on LinkedIn and Twitter.