Some investors appear to be, as per the old adage, ‘picking up pennies in front of a steamroller’.
When investing in credit markets, the spread earned over the risk-free rate is always predicated on taking some level of risk.
But in the case of US high yield bonds today, we don’t think investors are being compensated accordingly.
They are clipping ever-smaller coupons, while the limited scope for yields to fall means they won’t even be able to sell their holdings to a ‘greater fool’ for a higher price.
All the while, the spectre of a high-yield ‘blow-up’ - that proverbial steamroller - looms increasingly large in the background.
This reward for owning high yield bonds has not been meaningfully lower since the Financial Crisis.
Conversely, in several growth scares since 2009, this ‘spread’ has risen to nearly double the current level, or more, subjecting holders to a large capital loss.
Such market complacency is not justified.
Fundamentals and bondholder protections are deteriorating, and America’s economic outlook continues to weaken, with business surveys still subdued after a year of near-zero earnings growth.
The underlying sector exposures in the US high yield universe compounds such vulnerabilities.
The market is even crimped by negative convexity, whereby further appreciation is effectively capped by the many bonds in the universe being ‘callable’ by issuers should prices rise high enough. And it’s not like investors have no alternative.
We have seen US growth continue to slow - ‘catching down’ to the rest of the world - after a period of strong outperformance prior to last year.
While the ‘trade war’ may now be on the back-burner, Bernie Sanders uncertainty could lie ahead as we approach the election.
On the positive side of the ledger, the housing sector is well above trend after being supported by a dovish Fed via lower rates in 2019.
But for the US high yield market, strength in real estate is of little solace especially compared to the more vulnerable ‘consumer sensitives’ of consumer goods, retail, leisure, and media, which together comprise nearly a quarter of the US high yield universe.
We have seen a number of mounting headwinds for the US consumer sector; retail sales have been flat for six months now, aggregate hours worked in the economy are struggling to grow as the labour market hits capacity, wages are eating into profit margins, and retail junk-bond borrowers continue to face pressure from ‘Amazon-ification’.
Another 12 per cent or so of the US high yield market is in energy.
Even looking through the coronavirus impact that has seen oil demand and prices plunge, we see a US shale oil industry where the ability to turn an economic profit outside the mega-cap Oil Majors is being severely questioned.