Why Some Investors Are Betting the High Yield Party Is Over

Updated on
  • High-yield funds hit by biggest outflows in 16 months
  • Bank of America says credit spreads most clustered since 2014

Hasenstab Says Treasuries Are in Bubble That's Set to Pop

Call it the seven-year itch.

The torrid romance that doubled the global junk-bond market to $2 trillion since 2010 is losing the spark for a handful of investors, just like the supposed tendency to infidelity after years of marriage. High-yield bond funds suffered $10.5 billion of outflows last month, the most since December 2015, according to consultancy EPFR Global.

“This is an asset class we have loved for a number of years,” said Percival Stanion, head of multi-asset funds at Pictet Asset Management in London. “Now you have to believe in a very benign outcome for government yields, default rates and recoveries. That is a foolish way to invest.”

Stanion said he exited his position in U.S. high-yield bonds in recent weeks. At 20 percent in 2016, it had been the largest holding in his Dynamic Asset Allocation Fund. Meanwhile, Bank of America Corp. strategists said prices are ripe for a correction.

For now, they are the disillusioned few in a bull market keeping borrowing costs for speculative-grade companies near a three-year low. The reality check for investors will be volatility and disappointment over tax and infrastructure policies in the U.S., rather than prospective Federal Reserve interest-rate hikes, according to the Bank of America strategists who continue to recommend buying -- just at lower prices.

"Valuations in high yield are at or approaching their post-crisis highs," Bank of America strategists led by Michael Contopoulos wrote in a note published Wednesday. "A better buying opportunity will present itself after a summer backup; prefer selling into strength until then."

Market expectations that the Trump administration will take aggressive measures to boost growth -- spurring a steepening in the U.S. Treasury bond curve -- would challenge returns on debt issued by companies with weak balance sheets, CreditSights Inc. warned in a report this week. Speculative-grade borrowers are defaulting at a rate of 3.9 percent compared with 2.7 percent a year ago, according to the latest data from S&P Global Ratings.

To be sure, companies continue to price aggressive deals to an compliant investor base, catching follow-on demand in the aftermarket with high-yield debt still offering an attractive premium relative to higher-rated obligations, at least compared with previous credit-cycle peaks, according to CreditSights.

Exemplifying the current headlong rush to risk, junk bond spreads are currently more clustered together than at any time since October 2014, according to Bank of America strategists, an indication that investors aren’t matching up prices with company-specific risk.

The market is so exuberant that a Bank of America index is now two standard deviations below fair value based on a model that takes into account credit growth, default rates, Treasury yields and industrial production data, according to calculations by Lehmann Livian Fridson Advisors LLC.

“Prices have become irrational,” Stanion said. “You can’t invest on having the best of all worlds.”

— With assistance by Lyubov Pronina

(Adds default rate in 7th paragraph.)
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