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Investors bet against junk bonds at their peril

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In the past six months, investors across the globe witnessed the world turn upside down. Then, just as suddenly, sweeping coordinated action by central banks and governments left many major financial markets unchanged at worst — and at record highs at best. Just from looking at asset prices, things appear mostly right-sided, even though millions are unemployed, bankruptcies are piling up and new coronavirus outbreaks raise doubts about reopening efforts.

After experiencing such a whipsaw, could you blame investors for heading into the second half of 2020 wanting to bet against something? Anything?

While it’s still early days, U.S. high-yield corporate bonds are starting to look like the flashpoint for this anxiety. Investors pulled a whopping $5.55 billion from junk debt funds in the week ended July 1, the fourth-biggest outflow ever and the largest in more than two years, according to data compiled by Refinitiv Lipper. An additional $2.6 billion left exchange-traded funds tracking speculative-grade bonds last week, Bloomberg News’s Katherine Greifeld reported. Generally, high-yield pros are chalking this up to individual investors taking profits after the strongest quarter in more than a decade.

Some other troubling signs are starting to crop up, however. Traders are taking bearish options positions on the $27.3 billion iShares iBoxx High Yield Corporate Bond ETF (ticker: HYG), with about $2.5 billion in notional put volume changing hands on July 6, the most since June 11. Total call volume, by contrast, slid to the lowest in a month. Whether for hedging or just outright speculation, these wagers would suggest limited upside and potentially large losses ahead.

I admit, this is a tempting narrative. Maybe U.S. stocks can keep climbing thanks to the near-invincible large technology companies. Perhaps total returns on investment-grade bonds should be at a record high with the Federal Reserve buying a broad index of the securities and pledging to keep benchmark interest rates near zero for the foreseeable future, pegging borrowing costs at rock-bottom levels for creditworthy companies. But if the world is in for a slow and uneven recovery, what exactly is the case for junk bonds? They’re a natural asset class to show the first signs of skittishness.

Indeed, U.S. bonds and loans trading at distressed levels rose for a second consecutive week through July 2, by 5.9% to $369 billion, according to data compiled by Bloomberg. Before that stretch, that figure hadn’t expanded since April. While it’s still a far cry from the peak of $930 billion in March, this week-by-week chart of bankruptcies from Bloomberg’s Josh Saul shows that corporate America’s struggles are far from over:

The superlatives are stunning. More airlines sought U.S. bankruptcy protection this year than at any time since the global financial crisis. Energy filings grew at the fastest pace since oil prices collapsed in 2016. More retail companies turned to court protection in the first half of 2020 than in any other comparable period ever, with Brooks Brothers Group Inc. adding to that tally this week and the owner of the brands Ann Taylor and Lane Bryant reportedly soon to follow. Not all of these companies have unsecured bonds on their books, but the pace is nonetheless ominous.

Could the past few months have been a Fed-induced head-fake before the real storm? “Sharp corrections are common in highly volatile distressed cycles, and we think the exuberance may mirror spring 2008’s similar two-month window of calm, which didn’t last,” wrote Philip Brendel, a senior credit analyst at Bloomberg Intelligence. “That correction also reveled in Fed largesse as the central bank stood behind JPMorgan’s Bear Stearns acquisition in March 2008.”

Hearing comparisons to the global financial crisis might make an investor rush to a new ETF that Tabula Investment Management introduced this week (ticker: TABS), which effectively bets against 100 high-yield bonds by tracking the performance of the CDX North American High Yield Credit Short Index. “Investors need to review their exposure to high-yield U.S. debt and consider strategies for protecting against any rise in defaults,” said Jason Smith, Tabula’s chief investment officer.

For individual investors, it’s one thing to take profits after a blockbuster quarter. It’s quite another to make an outright bet against high-yield bonds. There are several reasons to doubt a full-scale collapse is in the offing, starting with the fact that junk-debt issuance reached $58 billion in June, the busiest month ever. That suggests a large swath of companies, particularly those rated double-B like the preponderance of the CDX index, have successfully raised funds to offset any immediate revenue shortfalls, which in turn lowers the stakes for the coming months if mutual-fund withdrawals persist.

Moreover, as I’ve noted before, distressed-debt investors have raised tens of billions of dollars for an opportunity to snap up cheap bonds and loans when companies run into trouble. Some already missed out on the biggest bargains in March; it stands to reason that they’ll be more eager to pounce at the first hint of another selloff, or attractive businesses falling on temporary hard times. On top of that, Bank of America Corp. estimates these investors might sell $200 billion of investment-grade securities in the next several months — money that would likely be deployed into riskier securities.

This wall of cash alone won’t save every company from bankruptcy, of course. But one reason that Hertz Global Holdings Inc. went bust while Avis Budget Group Inc. hasn’t is because investors lined up in early May to lend Avis $500 million for five years in exchange for a huge 10.5% coupon. Since then, Avis’s longest-dated bonds have rallied to 84 cents on the dollar from 56 cents, while the new securities trade at 114 cents to yield 6.3%, about the same as the Bloomberg Barclays high-yield index. It went from a company on the brink to an average speculative-grade borrower in just two months.

This kind of resolution seems more likely than a 2008 redux. Plus, the Fed wasn’t buying corporate debt and ETFs in 2008, nor was Congress so quick to extend lifelines to businesses and individuals alike. By all accounts, we’re living through a unique economic recession and recovery.

Investors shouldn’t assume anything about the behavior of speculative-grade debt in this environment. By all means, take some chips off the table if the persistent drip of bankruptcy filings is unnerving. But bet against the broad junk-bond market at your own risk.

Bloomberg News
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