Contagion! Is that still a word?

Liquidity in the lower rated junk bonds has already started to become tentative at best.  Over the last few months, volatility has risen significantly and a true reassessment of risk has begun with investors.  Bid-ask has been gappy and inconsistent, both on the downside and upside.   It has been fairly obvious for a long time that investors are not being compensated properly for the risk that they are taking on in the high yield market, particularly in the CCC-rated sector.  As pain from the energy sector spills over into the rest of the high yield market, and illiquidity becomes a reality, investors may soon be met with a reminder about what the word “contagion” means. 

HYG & JNK are trading at 2 year lows, and retail investors who blindly own high yield for the “safety of fixed income” are likely scratching their heads, as they wonder why and how their investment can lose in price.  They probably thought that it was just a safe yield that they could bank on.  30% of high yield ETF holders are hedge funds, and they will move the needle quickly when trying to avoid any losses from a headline risk type of trade, such as being long high yield.  Outflows have not started yet in these two ETFs, but if the past is any indicator, outflows will be large and fast.  July 2014 saw $12.6 B of overall high yield outflows; the impending problem could make July pale in comparison. 

As contagion takes hold, the illiquidity will likely become an exponential problem, as liquid equity ETF structures and daily dealing mutual funds struggle to create underlying bond liquidity, especially at a NAV that doesn’t represent significant gaps.  Once those gaps start to become apparent, trust is quickly lost in the structure itself.  NASDAQ released a white paper earlier this year, citing liquidity as the #1 ETF myth that could lead to investor losses. Lower rated high yield paper is starting to roll over…how will you be positioned? 

Enjoy the football today,

Richard Travia

Director of Research