This article from Bloomberg.com identifies five highlights from the trading of a high-yield bond ETF during the recent upheaval in the market. The news is mostly good.
Despite hitting its lowest price level since 2009, HYG is still up 50 percent since its inception in 2007. This shows how valuable income (better known as the ‘search for yield’) is to investors in junk bond ETFs. The chart below shows that the price return of HYG is -21 percent since inception, but if you throw in income it jumps to 50 percent. Conversely, the chart also suggests that HYG could have a lot more room to fall.
This post includes a good summary of what’s been happening in the high-yield bond market and what’s likely to happen. It also states that this shouldn’t be similar to the subprime mortgage market that led to the financial crisis.
About a month ago, hedge fund Ellington Management, run by well known bond trader Michael Vranos, put out a report comparing the high-yield mortgage market to the subprime market, saying that we’re likely to see a repeat of 2008. Ellington said there was now more high-yield debt outstanding, at $1.2 trillion, than subprime mortgage bonds. “We believe it is now time to batten down the hatches,” wrote Ellington.
But unlike in 2008, banks are not large holders of high-yield debt. They do lend money to hedge funds that invest in debt. And credit hedge funds have grow considerably in the past few years. But Diedrich says those hedge funds generally deploy less leverage than they used to, in part because the banks have made it so expensive (new regulation has made them do so). What’s more, energy debt, the portion of the market that investors are most worried about, only makes up about 15% of the high-yield debt market, and only about half of that debt is considered stressed right now.
People usually are surprised when I tell them that high-yield bonds are more likely to follow stocks than bonds. There is a lot of misunderstanding about high-yield bonds. But that doesn’t stop people from drawing conclusions about how the recent downturn in junk bonds and the failure of Third Avenue Value Focused Credit will affect markets and the economy. Here’s a post with interesting charts and information about high yield bonds.
Here’s something else to consider — this junk bond data only goes back to 1983. In that time interest rates have been in a free-fall. How relevant will the past interest rate cycle really be to the future cycle? It’s still a relatively new asset class, with many new investors to the space. Anyone trying to definitively make a case for risk assets one way or another based on the action of high yield will likely end up being surprised. There’s just not enough historical data to go on, nor is there a past cycle that will provide guidance for how the next cycle will look.
There’s a good chance you’re going to be seeing more and more high yield “experts” pop up in the coming days and weeks if these losses continue. A little perspective is necessary to better understand this segment of the bond market. According to Barclays Capital, there is just shy of $1.3 trillion in the high yield market. That number has more than doubled in the past 10 years or so.
The commodity crash, especially the oil price bear market, has roiled the high-yield bond market. Many of the small production and development companies funded their operations with a lot of high-yield debt. Now, those companies and their debt are in trouble. That’s triggered a lot of redemptions at high-yield bond mutual funds.
The next step in these cycles always is that redemptions are more than the market can handle. The funds can’t sell their bonds fast enough, or at least not at reasonable prices, to meet the redemptions. That’s what’s happening now. Third Avenue Focused Credit is unique among high-yield bond funds in several ways. It invests in deeply-distressed debt, which usually is reserved for hedge funds. It also invests in a lot of debt that isn’t readily marketable. It’s been the most volatile of the high-yield bond funds and in 2015 is the worst performer in the category, according to Morningstar.
Now, the fund is blocking shareholder redemptions. The fund says it won’t sell its existing holdings at fire sale prices. Instead, it has developed a plan of liquidation. It will pay out some cash soon but take time to liquidate the rest of its assets so that it can receive reasonable prices for them. It has no set time table for liquidating the assets and distributing the remaining cash.
U.S. corporate debt has fallen this year, weighed down by 3.48 percent losses in junk bonds that are poised to deliver the first annual loss since 2008, according to Bank of America Merrill Lynch Indexes.
Credit quality in speculative-grade debt is falling. For every junk-bond issuer that had its rating boosted this year, two have been downgraded, a ratio not seen since 2009, according to data compiled by Bloomberg. And companies are increasingly defaulting on their debt. Swift Energy Co.’s failure to make an $8.9 million interest payment last week raised the global tally of defaults to 102 issuers, a figure last exceeded in 2009, according to Standard & Poor’s.
Too often investors seeking income focus only on the current income. They don’t do enough hard analysis to determine if the dividend is sustainable or if it can continue to increase as in the past. They also don’t do enough stress testing. This article is a good analysis of the troubles at Kinder Morgan. The pipeline firm’s dividend and increases (which have increased at 14% annually for years) appear to be in trouble. Too much debt and problems from low oil prices are causing problems, and now many analysts wonder only when the dividend will be cut and by how much.
At this depressed level, the company’s 51 cents per share in quarterly payouts would generate a dividend yield of 13%. Looks juicy, but only if that dividend holds. And the odds of that are fading. Kinder’s dividend payouts were thought to be sacrosanct. Before Chairman Rich Kinder consolidated his four publicly traded entities (KMP, KMR, EPB) into one (KMI) in 2014, Kinder Morgan Energy Partners had grown its cash payouts every year since 1996, at a compound annual rate of 14%. Of course nothing can compound like that forever.
Investors have been fleeing Kinder because, measured against its $43 billion debt load, its cash flows look meager, its generous dividend unsustainable. Last week Moody’s warned that it might downgrade Kinder’s credit rating, now jut one notch above junk.
This article in Forbes discusses three closed-end funds that suffered lately. Now, they are selling at substantial discounts to net asset value and also have cash yields of about 13%. The closed-end funds are volatile, especially when rates are rising. But if you’re looking to take some risk to earn high income, consider them.
No, those yields aren’t yield. In fact, when you own individual tax-exempt bonds, your brokerage statement is likely to report a premium you paid over face value as part of your interest. Your own money is being returned to you, but the broker is allowed to report i as part of your yield. Read the details here.
So how can so many brokers and financial advisers be such astute bond-pickers that they can claim to be earning yields of 4% and up without jeopardizing your capital?
They can’t. Those yields are an illusion.
You would never know it from looking at your account statement, however. Brokers and financial advisers are able to report the yield on many municipal bonds without adjusting for an inevitable decline in their price—thus significantly overstating the income you will earn.
This is an important discussion, but one in which few investors participate. Today especially, you can’t do well knowing only about “interest rates.” You have to know about nominal interest rates (the market rates) and real interest rates (nominal rates minus inflation). This post does a good job of showing the difference. It explains that today nominal rates seem very high historically, but real interest rates aren’t. It’s something you need to know when considering whether interest rates are likely to rise soon and by how much.
But if you look at these measures on a real basis, they are actually both right in line with their long-term averages because inflation is so low at the moment. On a nominal basis things look scary. On a real basis, not so much. So which value matters more? That depends on whether or not inflation and/or yields pick up in the future and the magnitude of those moves in relation to expectations. As usual, things are not always as easy as they appear on the surface.
This post discusses a recent research paper that identifies a unique way to select a mutual fund that is likely to outperform benchmarks and competitors. Its thesis is that mutual fund companies know more about the quality of their managers than we do. So, demotion and promotion decisions by fund firms tell us who are the really good managers.
The key to picking a stock is thus to identify positive attributes that might aren’t known to others. Similarly, the key to choosing a mutual fund is to find a measure of skill that isn’t known to others – to have a measure of skill based on private (but legal) inside information. This is where an ingenious new paper by Jonathan, together with Jules van Binsbergen (Wharton) and Binying Liu (Kellogg), entitled “Matching Capital and Labor”, comes in.
A mutual fund is part of a fund family. For example, the Fidelity South East Asia Fund and the Fidelity Low Priced Stock Fund are both part of Fidelity. One of Fidelity’s jobs as a fund family is to evaluate the performance of each fund manager, to decide whether to promote her (i.e. give her an additional fund to manage, or move her to a larger fund) or demote her (take away one of her funds). They have access to a ton of information over and above past performance figures – just like scouting out a baseball player gives you much more information than you’d get from the statistics. For example, they can engage in subjective evaluations of her performance based on on-the-job observation, or assess whether poor performance might actually be due to good long-run investments that just haven’t paid off yet. Thus, a promotion signals positive private information, and a demotion signals negative private information.
Robert Shiller, the Nobel Laureate, doesn’t think so. Shiller recently went back to review a bond market analysis he did in his doctoral dissertation and first published professional paper. He updated the research and bond market forecasting formula used in the paper. His conclusion is that investors don’t have much reason to fear a bond market crash despite our very low interest rates and the Federal Reserve’s stated intention to raise interest rates.
But the explanation that we developed so long ago still fits well enough to encourage the belief that we will not see a crash in the bond market unless central banks tighten monetary policy very sharply (by hiking short-term interest rates) or there is a major spike in inflation.
Bond-market crashes have actually been relatively rare and mild. In the US, the biggest one-year drop in the Global Financial Data extension of Moody’s monthly total return index for 30-year corporate bonds (going back to 1857) was 12.5% in the 12 months ending in February 1980. Compare that to the stock market: According to the GFD monthly S&P 500 total return index, an annual loss of 67.8% occurred in the year ending in May 1932, during the Great Depression, and one-year losses have exceeded 12.5% in 23 separate episodes since 1900.