December 24, 2015    4 minute read

The High Yield Market: A Keg Of Dynamite?

   December 24, 2015    4 minute read

The High Yield Market: A Keg Of Dynamite?

For anyone who wins, another one loses (or not?).

Despite the few that believe that life is not a zero-sum game, where everyone can win and wedges in as a piece of a big puzzle (I belong to that minority), this may be a natural – although crude – rule of existence, therefore of business as well.

Markets are a good example of that. To simplify, let us think about the recent plunge in commodity prices. It has hit oil and gas producing companies, for instance, while it has supported those who benefit from low fuel costs, such as the airline industry. In other words, this mechanism underpins the cyclical pattern of any financial market, in which there are always investors who benefit from a trend and those who do not. Bullish outlooks follow the bearish and vice versa.

It is a story of winners and losers

In this regard, the equity and fixed income markets are usually highly negative correlated. The relation is not obvious as it may appear; however, it can be arguable that equities are the most profitable bet in a low-rate environment. As far as it concerns the bond market, it depends on your preference for a buy and sell or a hold-to-maturity strategy. In the first scenario, a low-rate interest environment would be more suitable, while investors should benefit from an increase in interest rates if the second option is taken into consideration. Within this scenario, corporate high-yield bonds (mostly known as “junk bonds”) play an interesting role and there are several and further external factors influencing their performances.

Therefore, it would be worth exploring what is happening, given the fears and volatility currently arising among investors.

“The high-yield market is just a keg of dynamite that sooner or later will blow up”

According to Carl Icahn, the American business investor and philanthropist, the high-yield market is facing a nightmare and the meltdown is just beginning. The first reason underpinning those fears regards the liquidity risk. It is increasingly difficult to find liquidity in the bond market – especially in the junk sector – and the recent hike in interest rates by the Federal Reserve occurred on Wednesday 16 December has not helped. The upcoming approval of the MIFID II adds uncertainty in the markets and investors are becoming cautious about their decisions. Furthermore, what has happened to a few hedge funds has been crucial. Third Avenue Management LLC, the largest U.S. junk-bond exchange-traded fund, in the last two weeks closed at its lowest level since 2009, then blocking its clients from withdrawing money from about $1 billion of junk bond fund. On the same way, New York-based Stone Lion Capital Partners, which manages approximately $1.3 billion of assets, has faced a huge number of redemptions’ requests, barring them from a $400 million credit hedge fund. This happened a few days before the Federal Reserve had raised interest rates, which has worsened the situation and has sparked a historical sell-off in the high-yield market.

Obviously, investors are concerned about the risk of contagion. High volatility and a subsequent market illiquidity, coupled with an exacerbating regulatory environment requiring banks to deploy more capital, are worsening current situation. After those redemptions, funds are less likely to absorb liquidity and market sentiment may deteriorate very sharply.

As previously outlined, the recent interest rate hike by the FED represents a big risk. Indeed, it will have a greater impact on those high-yield companies, which are increasingly sensitive, given their much more levered balance sheet position. Repaying debt-holders will be harder than expected.

However, the main threat comes from the plunge in commodity prices, which hinders companies from issuing more debt and makes them increasingly risky. Energy and mining companies account for about 15% of US high-yield issuance. During the summer, Fitch Ratings changed its 2015 U.S. high-yield default outlook to 50-100 basis points from 1.5-2%, reflecting the impact of

“languishing oil prices, weak coal demand and burdensome regulation have had on energy and metals/mining companies during the first half of the year”

The outlook is cloudy, and providing investors with forecasts and a clear strategy on how to manage their funds in the upcoming months would be difficult. Once market volatility stabilises, perhaps it will be easier. Hopefully.

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