High Yield: Are ‘Fixed Income People’ Smarter Than ‘Equity People’?

An Equity Bounce? ‘Fixed Income People’ Not Buying It

Since September 29^th, the S&P 500 has bounced back from 1884 to 2013, a bounce of almost 7%. Are we done with selling? Not if the ‘fixed income people’ have their say. The Merrill Lynch CCC or lower index spread has not budged. It went from 12.7% on 9/29 to… exactly the same level i.e. 12.7% on 10/7. You can check OAS for Merrill Lynch indices here (need to open a free account).

If spreads do not tighten soon, then this bounce will not last.

But isn’t high yield index mostly about energy? Energy, after all, is the highest weight in that index. Here is Merrill Lynch’s own response to this argument, from 9/29: “Point out the troubles in Retail and Semiconductors and pat comes the reply that one’s always been structurally weak and the other’s going through a secular decline. Mention the stirring in Telecom and we’re told that it’s isolated to the Wirelines. When we began writing this piece, Chemicals and Media were fine, and Healthcare was a safer option; not so much anymore.”  Here is a detailed summary of the UBS and Merrill reports on the state of the high yield market.

History Does Not Repeat, It Rhymes

We have seen above that junk spreads rising from low levels are a good indicator of serious turbulence in the financial markets. But is it only about spread levels? Consider the chart of corporate debt issuance in $ billions starting in 2005. Anything stand out? High yield credit issuance has actually been falling for three years now (for 2015 we simply assumed that the remaining months of the year will repeat 2014). Interestingly, it was also falling in 2006 and 2007. What is even more interesting is the growth of investment grade debt issuance over the past hree years. It started at historically high levels in 2012, continued with an 8% rise in 2014, and a projected 10.1% rise in 2015.

If you were perplexed about how exactly the Fed’s zero interest rate funding actually gets into the markets, here is a big part of your answer. Corporations issued a great deal of debt and bought back stocks at a historic pace. So if this rate of investment grade issues slows and market volatility keeps increasing, watch out.

What Does This Mean for You?

1. Caution on high yield debt.
   The junk debt market is in serious trouble with contagion spreading. If your clients own high yield, make sure they understand that it is a very risky investment. The good thing about high yield right now is that the yields are, well, high. But it may be prudent to avoid the space for now or as Jeff Gundlach put it: “I’ll think about buying when it stops going down every single day.”
2. Become a ‘fixed income person’.
   Every advisor must understand financial markets. Today it is just as important to understand and watch the dynamics of high yield bonds and investment grade bonds, as it is to know where the Dow closed today. Your expertise will pay off when you are discussing risk with clients and they will be able to make informed decisions.
3. Understand the exposure that your clients might have to corporate debt in various funds.
   Investment grade exposures can be quite varied and there is a big difference between AA and BBB. If you find that your clients hold a lot of BBB debt, do not consider it a safe haven like treasury or AA debt.