Investor sentiment in the high yield bond market seems lackluster—while the stock market has moved to new highs, the high yield bond market has not responded with a new high of its own. Investors balked last week at the terms offered on a planned issuance by McGraw Hill Education, a private equity-owned publishing company, leading to cancellation of the $250 million deal. Despite offering a fixed 10% yield, the covenants allowing for pay-in-kind (PIK) interest repayments—which allows payment either in cash or more debt—didn’t draw investor interest, as reported here. Market events such as these can suggest either weakening credit quality or a drop-off in investor interest, both of which can indicate softening bond prices.
Investor sentiment also looks weak with regard to the carry trade, in which traders borrow at lower rates to invest in riskier, higher yielding assets. Unwinding of the carry trade could explain the recent high trading volume on days when the high yield market is down. The carry trade could become even less attractive if short term rates rise—especially if the long end of the curve starts to move higher with stronger growth and inflation trends based on the stimulus from the tax reform bill. The yield spread would narrow even further, offering relatively marginal additional yield for the risk of owning high-yielding bonds of lesser credit quality. In short, the cost of the carry trade is increasing—which may reduce the “bid” for high yield bonds during 2018 as short-term rates move higher.
On the quantitative side, price indicators have improved recently—for example, with robust employment figures—but further improvements in our read on market technicals would be needed before we’d consider re-entering high yield in our tactical strategies for the purpose of either receiving coupon payments during a sideways market and/or for potential capital gains on the bond values themselves. Still, we have to be patient, with many institutional investors selling high yield, we think the risk of re-pricing lower remains high.
Bond yields present a quantitative risk that bears emphasis and reiteration. As of December 12, the 10-year Treasury yield is at 2.38%. If we view the 2.38% level in relation to its 52-week range (2.06-2.61%), the yield is 15% off its low (2.06%) and about 10% under its peak (2.61%). Moreover, the narrow October price range represents a price pattern that, if broken, may cause yield to challenge the 52-week high (2.61%) or break lower toward the 52-week low (2.06%).
In short, sentiment is mixed-to-weak, and model inputs are improving—but still flashing “caution.” In our view, a new intermediate-term trend has yet to emerge. Deterioration is especially likely in the event of a stock-market correction, though a quick correction followed by stabilization could well create conditions for another leg up in high yield prices. Alternatively, if high yield as a sector can make a new high over the mid-October price level, that would be an encouraging indicator and suggest the market is stable enough to enter for coupon payments and perhaps some capital gains if the long end of the curve continues to flatten.
It should not be assumed that investment decisions made in the future will be profitable or guard against losses, as no particular strategy can guarantee future results or entirely protect against loss of principal. There is no guarantee that the strategies discussed will succeed in all market conditions or are appropriate for every investor.
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