(Bloomberg Gadfly) — In recent years, whenever U.S. credit markets have become mired in boredom and melted up out of sheer habit, traders start worrying about junk bond bubbles.
Now is no different. It has been a notably unremarkable year for credit traders despite populist upheavals in Europe and the U.S. and subsequent unpredictable policies and rhetoric. Meanwhile, yields have fallen to 5.2%, from more than 10% last year, with average prices rising back above 100 cents on the dollar from last year’s low of 83.6 cents, according to Bloomberg and Bank of America Merrill Lynch index data.
Scott Minerd of Guggenheim highlighted his credit concerns on Monday at the Milken Institute Global Conference in Beverly Hills, California.
“One of the things we’ve been doing is trying to lean against it a little bit with our clients,” he said of the hot credit markets. “To get them to understand that we’re late in economic expansion, credit spreads are extremely tight, especially in high-grade corporate debt and high yield.” Peter Tchir, head of macro strategy at Brean Capital, also recently recommended investors sell their high-yield debt holdings, especially via index funds that in his view are poised to underperform more significantly.
It’s hard to be too wrong. This debt is overvalued by any historic measure, especially when juxtaposed with a credit cycle that’s exhausting itself. Companies are adding debt faster than they’re increasing revenues. And as BlackRock’s Larry Fink noted recently, the U.S. economy is slowing down, not speeding up.
So there very well may be a cooling off period in the near term.
But it’s hard to see the long-awaited implosion of this $1.3 trillion market happening imminently. (This is something that traders have been warning about for years.) In fact, it’s hard to see even a medium-sized pullback unless there’s a more rapid deterioration in specific telecommunications and technology companies, which are accounting for an increasing share of the market. The probability of that is low in the next few months.
Benchmark yields are still low, giving bond buyers incentive to take more risk. And even though the Federal Reserve has started raising short-term interest rates, that has only led investors to buy longer-dated notes with the expectation that tightening monetary policy will mute growth in the decades to come.
Big investment managers who are expressing caution about riskier U.S. company debt may not be entirely wrong, but it also hasn’t escaped them that it presents an opportunity. Namely, their warnings give them arguments to make for investing in actively managed credit funds as opposed to passive strategies that hew to broad indexes.
The argument goes like this: Investors are less and less likely to earn big returns by plowing into the biggest high-yield bond exchange-traded funds, as they’ve been doing, than giving their money to more skilled money managers.
The idea is that while there are few screaming buys, there are some securities that would be good to avoid. Indeed, this renewed belief in human judgment seems to be gaining some traction among bond buyers. For example, these active taxable debt funds received $96.3 billion in the 12 months through March, according to Morningstar data. This is still less than the flows into passive bond funds in the period but looks pretty good compared with the nearly $270 billion of outflows from active U.S. equity funds in the period.
Undoubtedly there will be bumps ahead for the U.S. junk-bond market, but it’s hard to see an imminent widespread meltdown. That’s not going to stop some money managers from arguing that it’s time for humans to take over the navigation in a market that they contend is increasingly perilous.
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