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High yield (‘HY’) bonds, or what are better known as junk bonds, have dominated the front pages of the financial press in recent months.
When Federal Reserve (‘Fed’) Chair Janet Yellen addressed Congress in mid-July, she mentioned that certain parts of the market had become overstretched, and specifically mentioned high yield bonds, among other areas such as biotech and social media stocks.
According to data provider Lipper, since the first meaningful outflow in late June, US high yield bonds have experienced cumulative outflows exceeding $20 billion. There haven’t been outflows of this magnitude since Ben Bernanke’s testimony in May 2013 when his speech sparked the now-famous taper tantrum. The growth of the market is also quite startling with the market for dollar-denominated junk-rated debt expanding more than eight-fold since the end of 1997 from $243 billion to over $2 trillion today as investors have sought relief from the financial repression brought on by near-zero interest rates.
Paradoxical as it may seem, it is the Fed, among other central banks like the Bank of England and the European Central Bank, adopting zero interest rates that has led to such a bubble in the bond market. By pursuing a policy of zero interest rates for the last five years, which sets the base price for all other fixed income assets, policy makers have created a bubble in the more speculative areas of the market. July proved to be a tough month for HY credit as geopolitical concerns, the situation at Banco Espírito Santo and Argentina’s default all seemed to weigh on market sentiment. However, more worrying times may be ahead as it is estimated that the Fed will complete its Quantitative Easing (‘QE’) programme in October.
As Figure 1 shows, HY bonds have enjoyed a great run in recent years, however, this has pushed yields to record lows. Having yielded nearly 20% at the end of 2008, today they are yielding just 6.5% and the risks are clear. It’s true to say that a 6.5% yield in a zero rate world is significantly higher that what you can get on deposit at your local bank, but given the inherent risk of investing in this segment of the market, we do not think the yield in itself is enough of a premium to hold these investments. As we get closer to higher interest rates, we think that further gains will be harder to come by.
What is clear to us is that savers and investors are being forced to take on more risk to meet their desired return and income needs that they would expect in a more normalised interest rate environment. An important lesson from history tells us that when investors get desperate, it usually leads to problems. In our view, this underlines the problem of pursuing zero interest rates for a prolonged period of time, and we have often asked the question - have central banks already sowed the seeds of the next crisis by adopting such policies? In this case, we think they already may have.
Liquidity in this asset class has been reduced by lower corporate bond inventory levels at investment banks following the ‘Dodd-Frank’ regulation changes. The Dodd-Frank regulation changes reduce the amount of corporate bond inventory banks can hold on their balance sheets and we believe this could potentially exacerbate a sell-off in the future. The major fear is that, if everyone heads for the exit at the same time, the high yield market will simply seize up - a situation similar to the sub-prime property market during the crash - and spill over into other segments of the market.
What seems clear to us is that the pursuit of income has led to an unhealthy scramble for yield, as investors are desperately pushing themselves out the risk spectrum to be able to generate any meaningful returns from their savings and investments.
It is still early days since Yellen’s comments, and whether or not the initial outflows in junk bonds lead to something more pernicious, we will have to wait and see. However, we would rather err on the side of caution and not chase yield any higher in this particular space.