Cracks Start To Show In High Yield As Investors Turn Cautious

The high yield new issue market came roaring back to life last week according to Bank of America’s credit strategists Michael Contopoulos and team, but despite record levels of new issuance, it appears investors are turning away from high yield credit market.

Cracks Start To Show In High Yield As Investors Turn Cautious

For the week to Thursday 9 March $17.3 billion of new high yield issuance was priced, the largest volume in two years. However, while the market excepted this new issuance, outflows, specifically ETF outflows, have caused spreads to widen. BOA’s high yield credit team writes:

“Last week was one of the busiest of the year on several fronts. Specific to high yield, the market absorbed the largest amount of issuance in two years, with $17.3bn priced, while outflows, specifically to the ETFs, caused some investors to begin to become nervous on valuations and the sustainability of what has been a drawn-out 13-month rally. As such, yields have backed up 44bp since the first of the month, while spreads have widened 32bp.”

What’s more, BOA’s monthly Credit Investors Survey revealed investors are significantly more bearish towards high yield valuations than they have been at any other time since 2008. The net proportion of investors expecting wider spreads one year from now jumped to 76% from the previous 23% in our January reading. Michael Contopoulos comments that this figure represents the greatest proportion of investors that they expect wider spreads since May 2006, when high yield was trading at just 288 bps.Similarly, a net 85% of investors now find spreads overvalued compared to 67% in January, the highest figure since April 2007. With bearish sentiment rapidly gaining traction the survey’s respondents indicated that they have adopted a net underweight stance on high yield for the first time since 2008.

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Contopoulos opines that this rise in bearish sentiment may not be a bearish signal to sell high yield based on past trends. “Case in point, the last time investors were this convicted on spread widening and found spreads more overvalued, high yield actually tightened by 22bps over the next year,” he writes. “Similarly, the last time a net proportion of respondents were underweight (December 2008), high yield returned an all-time best 65% over the next 12 months” Contopoulos continues.

Nonetheless, BOA’s credit team are cautious about what the future holds for the high yield market. Specifically, the team believes investors may have “forgotten about the difficulty of selling bonds to generate liquidity” and after a 13-month bull market in energy bonds, “should fears of persistently low oil begin to affect sentiment…. Outflows and widening reminiscent of late 2014” may develop:

“The big wild card, however, is likely to be flows. Although cash levels have jumped since our last investor survey in January, we worry that investors have forgotten about the difficulty of selling bonds to generate liquidity if needed. Should mutual fund outflows follow ETF redemptions, we could see the market move in a similar way as during the taper tantrum or Ukraine. We are looking to two key data points in the near term to help us determine how big of a risk outflows could be. The first is five-year rates. With the probability of a hike this week at 100%, and our economists now thinking there will be three in 2017, should the market begin to anticipate a June rate increase, we think high yield yields are likely to continue to climb and outflows ensue.”

“The other key metric in our sights brings flashbacks to 2015 — a fall in crude. With the Energy index just 50bp wide of the overall high yield index, the market has made an unbelievable run over the last 13 months. Although much of the tightening was due to higher-quality IG issuers dropping down into high yield and 26% of the market defaulting, there is no doubt that optimism for the space has grown. Should fears of persistently low oil begin to affect sentiment and E&P companies, however, we think the psychological impact, if not the fundamental impact, is likely to cause further outflows and widening reminiscent of late 2014. Absent these catalysts, however, its mid-year policy disappointment we wait for in the two months before the August recess.”