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Good morning. I am still trying to avoid writing about inflation, but the stuff turns up everywhere. I’ve been meaning to return to the high-yield credit market for some time, and the European Central Bank provided a way in yesterday. But 10 minutes into the first call with the first source, the conversation had turned to — inflation. Maybe best not to fight it? Anyway, email me or Ethan at firstname.lastname@example.org or email@example.com.
“Signs of exuberance are increasingly visible in some financial market segments as real yields fall and the search for yield continues. Real yields fell to all-time lows amid indications of a moderating pace of the economic recovery and increased inflationary pressures, incentivising risk-taking in financial markets …
“Issuance activity in high-yield corporate credit markets has reached new highs in 2021. Despite large issuance volumes, spreads remain at record lows, pointing to strong investor appetite for risky assets.”
People are, undoubtedly, selling a lot of risky financial instruments, and other people are paying very high prices for them, all over the world. This is not news. But the ECB is particularly worried that investment funds and insurance companies, spurred on by the collapse of real yields, have piled into the risky end of the credit spectrum. Here is an only somewhat confusing ECB chart of this phenomenon:
On the left panel, as the blue spots move down and to the left, they represent increasing fund exposure to less liquid, lower credit quality assets. The size of the bubbles represents an estimate of duration risk, that is, how much the funds will get hurt if interest rates should spike (as they might if inflation gets out of hand and central banks have to tighten the screws). On the right you see how insurance companies have significantly increased their exposure to the lowest-quality investment grade assets — triple-Bs, in the jargon.
Meanwhile, in the US, this (from Bloomberg, last week):
US high-yield bond sales reached an annual record of $432.4bn on Tuesday as companies rush to lock in low coupons while they still can. Cheap funding costs have unleashed a prolonged pile-on of debt issuance, and borrowers have been hurrying to take advantage of the opportunity before the Federal Reserve eventually raises interest rates. That could come sooner than expected amid inflation pressures, though Fed chair Jay Powell is still preaching patience as of last week. This dash has taken 2021’s issuance beyond 2020’s high mark $431.8bn, which topped a prior record set in 2012.
Wild demand for yield, and a benign economic environment engineered by loose fiscal and monetary policy, has had a predictable effect on junk bonds. They have become very expensive, and their yields are absurdly low. Here are the spreads — the additional yield over sovereign debt — on European and US high-yield debt indices:
European spreads have been, for months, at their pre-pandemic lows; US spreads are lower still. This seems crazy. Yes, corporate balance sheets and profits are both sparkling. But surely bond markets should be forward-facing, and we can recognise that the party is winding down. The pandemic’s waterfall of fiscal transfers to consumers is drying up, the US government deficit will be smaller next year and central banks are starting to reduce quantitative easing, and a rate tightening cycle is expected to begin in the middle of the year. Shouldn’t spreads be creeping up?
Maybe not. I spoke to Marty Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors, and a longtime observer of the high-yield market. He has a five-factor econometric model of fair value in high yield, which looks at economic activity, the availability of credit, default rates, Treasury yields (which generally move inversely with spreads) and quantitative easing. As of the end of October, high yield spreads are 124 basis points below fair value, according to the model, about one standard deviation away from normal.
“It is fair to describe the market as expensive,” Fridson says, but not massively so. He waves away the notion that the flood of issuance means yields must soon rise, saying that historically, issuance responds to demand, rather than the other way around.
The key factor in keeping fair value low in recent months, Fridson says, had been greater availability of credit — which means companies have an easier time refinancing their debts and are less likely to default. Here are the results of the Fed’s loan officers’ survey, which shows the net number of banks tightening lending standards. It has stopped falling, that is, credit availability has stopped increasing:
That may be an ominous sign. But there is another factor explaining the fall in spreads in the US, which Tomas Hirst of CreditSights explained to me: the quality of the index has improved. At the lowest-quality end, triple C-rated and distressed companies have either gone bankrupt or, more frequently, repaired their balance sheets, meaning their yields have fallen from around 10 per cent to, say, 6 or 7. And there has been a lot of issuance at the high-quality end of the market — double B-rated bonds, the highest rung of junk, are now over half of the market — again dragging yields down. The index as a whole has become less risky.
The high-yield market is hot and it is expensive. But spreads are not wildly out of line with history or with economic fundamentals. If the ECB or any other central bank is looking for wild mispricing that presents a risk to financial stability, they might want to look not at corporate bonds, but at sovereigns, the market they have been intervening in directly.
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