Liquidity - more than defaults - rules the high-yield debt market. And when defaults rise, price moves will be even more dramatic

By Andrew Allentuck | January 2015

High-yield - or junk - bond prices have been on a roller-coaster ride in the past few months. Prices tumbled in mid-October, then recovered by early December, when their yield was about 6% - about 467 basis points (bps) over what U.S. five-year treasuries paid at the time.

The rise in junk bonds' prices has been sustained over the past two years. Still, you and your clients have to heed new rules: it's angst over liquidity that's moving junk, not fear of default.

The high-yield sector, as a whole, has produced a return of 154% since the beginning of 2009, which beats the MSCI all-countries world index's 83% gain in the same period. Yet, junk has become much more volatile, and for reasons that have nothing to do directly with fears of issuers skipping out on payments of interest or payback of principal.

High-yield bond prices dropped drastically in 2008, 2011 and 2013. And in the latest tumble, which took place from Sept. 10 to Oct. 13, 2014, the average price of U.S. high-yield debt issues fell by 2.5%, reported Fitch Ratings Inc. in its review of U.S. leveraged finance released on Oct. 30.

Money has moved out of risky bonds to safety. The exodus to quality bonds reached a crescendo on Oct. 15, when buyers pushed U.S. T-bond yields down by 33 bps - a massive move in the bellwether T-bond.

Why the big move out of junk happened can't be explained by fear of defaults. Prospects for defaults did not change before or during the mid-October junk bond rout. For all industries, average annual defaults held steady at about 1.5%, the 2013 level, and actually declined from 1.9% in the second quarter, according to the Fitch report. In September alone, defaults were running at 2.2%, vs the historical average of 4.3% for the period from 1980 to 2013.

But rather than default risk, it was a rush to liquidity that caused the switch in investments to U.S. treasuries from junk. As a result, high-yield bond sell-offs are probably going to get more dramatic as junk bonds, which are hard to buy and harder to sell, are getting more technical.

The junk market has expanded from hedge funds to popular assets packaged as exchange-traded funds (ETFs). Now, when clients get nervous and want to raise cash, they can sell stocks and, with no difficulty, sell high-yield bond ETF units. The result of this change in the junk market showed up in the mid-October high-yield price tumble. On June 30, 96% of junk bonds were trading above their issue prices; by Oct. 21, only 77% of junk was above their issue prices.

Junk bond price volatility is likely to increase. That's because banks are generating their own brand of homemade, high-yield debt in the form contingent convertible bonds (a.k.a. CoCos), which will help banks meet tougher regulatory standards.

In the event of massive loan losses, which presumably will drive down a bank's share price, CoCos will allow the bank to suspend interest payments on those CoCos. And if there's more pressure on capital, the issuers can convert these bonds to equities. But, notably, these convertibles will turn into common shares at the worst possible time and dilute previous shareholders' equity.

The average coupon on CoCos was 7.25% in October, about double the rate on senior bank bonds, reports Bloomberg LP. More CoCos are to come, and all will have the effect of shoring up senior bank bonds and their holders. CoCos will do this at a time when bond risk in general is higher. "Quantitative easing has reduced interest rates, and so, raised bond duration," says Barry Allan, president and CEO of Marret Asset Management Inc. in Toronto.

Given the higher level of risk caused by increased duration and the reduced liquidity caused by a bank's need to cut holdings of dicey bonds, spreads between corporate bond prices and, especially, subinvestment-grade bonds are going to increase, says James Hymas, president of Hymas Investment Management Inc. in Toronto: "It is liquidity, not default risk, that is moving prices and yields in the junk debt market."

When the market is "risk on," investors load up on high-yield debt; then, when the market is "risk off," the rush to sell ensues. In order to pass stress tests, banks have to reduce their high-yield debt holdings. That has led banks to sell junk in favour of lower-yielding government bonds and to reduce inventories of junk.

The result is that when investors want to reduce junk bond holdings, it is harder to find buyers. That widens spreads, increases volatility and turns what would have been small moves in junk yields into massive yield shifts as investors head to liquidity.

The fundamental lack of liquidity in the high-yield market has been exacerbated by ETFs, says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. That's because ETFs have opened the high-yield market, formerly the preserve of institutions and big investors, to anyone with a brokerage account. However, the presence of more investors in the market doesn't change the fact that most junk bonds seldom trade - and that it's tough to find counterparties most of the time.

"The door into the high-yield room is narrow compared with other asset classes, and there are now more people in that room," Kresic says. "So, when there is a reason to get in or out of the room, price swings are going to be larger."

The bottom line is that liquidity - more than defaults - rules in the high-yield debt market. And when defaults rise, price moves will be even more dramatic. This is not a market for the timid.

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