Does the jump in high yield spreads say anything about the global economy?
Markets have focused on oil prices as a barometer of health in the global economy and stock markets, but historically high yield spreads over the risk-free rate have been a much better indicator.
Spreads have widened considerably lately, and now “the market as a whole is pricing in default rates that are approaching the kind of levels seen in 1997 and 2008,” explains Chris Iggo of Axa Investment Managers.
FED STEPS IN?
The fear of defaults in highly leveraged energy companies and emerging market debt is driving prices. It could get so bad that the US authorities are forced to intervene, argues Walter Price of Allianz Global Investors.
“What we are monitoring is the bond market. A lot of people are looking at oil and saying that it’s an indicator of the stock market,” he says.
“We think eventually the Federal Reserve will react to this increasing risk premium which is hindering finance for a lot of companies that need it. We think the Fed are already backing the idea of raising rates, but they haven’t come around to the idea of easing credit conditions for companies which don’t have have a high credit rating.”
Although at market level high yield spreads show signs of stress in the sector, this is mostly confined to the battered energy names, says Simon French of Panmure Gordon.
The high yield sector is dominated by US companies. Many of these are shale oil companies which leveraged up when oil prices were high and have been suffering through the last 18 months of cheap oil.
“It would concern me if high yield spreads had blown out across all sectors. What we are seeing shows most non-commodity corporates are not struggling to find finance right now,” says French. “It is fairly readily available and affordable.” The consumer and industrials sectors are doing much better than energy, he adds.
French argues it’s more dangerous if negative headlines coming out of the distressed energy sector spook investors enough for them to pull out of financing other bond sectors.
High yield spreads are also a sign that risk is off the table for many investors this year, says Adrian Lowcock of Axa Wealth.
Meanwhile, some experts are warning a liquidity squeeze is starting to appear in bond markets. The lack of liquidity has been a much-discussed issue over the last several years, but with the smorgasbord of market risks facing investors, from China to European banks, this may be the year those fears are realised.
“The scramble we may see this year is for liquidity,” says Alan Durrant of Harwood Capital, adding that it’s the one risk many investors are not properly considering.
It’s already appearing, to some degree. “The credit markets are currently dislocated and long-held concerns about market liquidity are playing out in wide bid-offer spreads and an inability to trade easily in large ticket sizes,” says Iggo.
He notes that credit default swap (CDS) indices have widened significantly, and in the case of some credits, this is because investors can’t exit the bonds themselves.
“Depending on the names, there have been some examples of CDS spreads widening much more than the intrinsic bond spreads – with market participants using the CDS to express a negative view on credits when doing so in the cash market is more difficult,” Iggo explains.
Durrant adds: “We are already seeing people saying they are nervous of emerging markets, then they are nervous of high yield, then investment grade bonds. We may be the canary singing in the coalmine but we need to start thinking of this well in advance."
However, things would have to get much worse for a full-scale unravelling of the bond market to occur. Although Iggo says prices in CDS and cash bond markets do indicate stress, “there has not been any real sign of capitulation from core credit investors, not like we saw in 2008”.
Liquidity would be a particularly difficult issue for investors in fixed income funds offering daily dealing – and there’s currently $33 trillion in such funds around the world, Durrant says. “There’s a massive systemic risk that funds could become weekly or monthly priced,” he adds. This would be particularly tough on pension funds, institutions and anyone reliant on fixed income payments. Many fund managers hold cash levels of around 5 per cent during periods of falling markets, to cater for outflows. At the moment, mass redemptions are yet to appear.
Liquidity has been a concern in fixed income markets since the financial crisis, as in the aftermath many banks pulled back from trading fixed income. They had provided a liquidity lifeline to the market, and their trading has been sorely missed. That’s also coincided with an explosion in the amount of fixed income securities issued. Since 2000, the size of global bond markets has tripled with more than $100 trillion in outstanding debt.