Articles & stories

The High Yield Seesaw

The past five years have been interesting times in high-yield debt markets, punctuated by periods of sharp volatility followed by full recoveries. What will be the next catalyst for a selloff?

The past five years have been interesting times in high-yield debt markets. On one hand, the world's major central banks have been holding interest rates near zero for an unprecedented length of time, encouraging a hunt for yield that has turned the very phrase "high yield" into an oxymoron. Average junk bond yields were below 6 percent for much of 2013 and 2014, compared to the 8 percent-plus levels that were common before the financial crisis – never mind the 10 percent-plus rates that prevailed between 1998 and 2003.

Reduced Liquidity Boosts Volatility

On the other hand, a drastic reduction in market liquidity has made for punctuated periods of intense volatility – dramatic selloffs followed by full recoveries. One reason for that: Financial institutions have drastically reduced the assets available for trading in order to meet new capital requirements mandated in the wake of the financial crisis. Fixed income, currency, and commodities trading assets at large brokers have declined 600 billion dollars – some 30 percent – between 2009 and December 2014, according to Credit Suisse estimates. The already relatively illiquid world of high-yield bonds has thus become even more illiquid, with sharp moves coming not only as a result of credit risk, but also with the onset and easing of unpredictable macroeconomic jitters, according to Credit Suisse Head of Global Leveraged Finance Strategy Jonathan Blau.

Concern for Global Deflation Steer Markets into Risk-off Mode

The sharp drop in oil prices at the end of last year prompted the latest such panic. There was legitimate concern that highly leveraged energy companies would run into difficulty meeting their bond obligations as oil prices fell. But Blau says the principal reason for the selloff was that the decline sparked fears of global deflation that sent markets into risk-off mode, which hurt riskier assets such as high-yield bonds across-the-board.

High Yield Bonds and Oil Prices Dance Together

The trouble in high yield followed on the heels of oil's own. On June 19, the one-month forward price of Brent crude, the benchmark for global oil prices, hit a high for the year at nearly 115 dollars a barrel. Four days later, yields on high-yield bonds troughed at 5.1 percent. When oil prices began falling thereafter, bond yields rose right along, peaking at 7.7 percent on Dec. 16, when Brent was trading at just 59.75 dollars a barrel. There was another important December milestone, too. Europe slipped into deflation for the first time since 2009.

Energy Credits Hit Hardest in Q4 of 2014

The entire high-yield sector saw a flight to quality in the fourth quarter of 2014, but energy credits were the hardest-hit. Total returns on energy bonds roughly tracked Credit Suisse's overall high-yield index until late September, when oil prices sank into the low 90 dollars. By the time high-yield troughed on Dec. 16, energy credits were showing an abysmal -14.8 percent year-to-date return, compared to 1.89 percent for non-energy credits and -0.94 percent for the index as a whole. (Energy makes up some 15 percent of the index).

Blau says the reduced liquidity available in the marketplace exacerbated the impact of what was actually a relatively limited selloff. "Some of the price losses that occurred through mid-December were due to the fact that there were very few sellers, but those that sold were determined to exit their positions," Blau says. "The buyers who came in knew they could extract a large premium."

Risk-off Sentiment has Decreased

In the end, Blau says, high-yield bonds ended up priced well below "fair value." But since that time, risk-off sentiment has gradually abated, helped along by strong U.S. economic data and the announcement of a quantitative easing program from the European Central Bank. A tepid recovery in oil prices over the last two months – Brent crude has rallied from a low of 47.20 dollars a barrel in mid-January to 58.56 dollars in early March – has also bolstered the high yield market, with yields back down to about 6.5 percent. Total return for 2015 year-to-date is 2.5 percent overall, and energy has recovered strongly, returning 4.2 percent.

Investors Are Concerned About Pace of Rate Hikes

One thing that hasn't changed much, however, is the liquidity situation, and the increased likelihood of another bout of skittishness. The most obvious catalyst is an expected rate hike from the Federal Reserve. Blau says investors are likely to be more concerned with the pace of rate hikes than the timing of them, but notes that tightening could certainly put a strain on high-yield markets given the existing low levels of liquidity.

Once upon a time, if there weren't enough willing buyers, banks would act as principals by holding bonds on their own books. But now that financial institutions have pared back their trading assets, investors are exposed to much more volatility than in the past. It remains to be seen just how much of an impact a Fed hike will have on the market – or if it will happen this year at all. But hike or no hike, the high-yield world is ever more vulnerable to sudden fits of nerves.

This article has originally appeared in The Financialist.