Gadfly

Junk-Bond Traders Are Increasingly Just Buying Stocks

They see low returns in debt and less risk in equities. But this will end badly.
From
Photographer: Andrew Burton

If you peel back the hood on this year's most successful corporate-debt funds, one thing becomes apparent: The more risk they took, the better they did.

While in some cases that meant diving into lower-rated credit, in others it meant leaving the junk-bond world entirely and just buying more stocks. Indeed, the best-performing fund in the high-yield debt category so far this year, as ranked by Morningstar Inc., is the Fidelity Capital & Income Fund, which boosted its equity allocation to more than one-fifth of its fund earlier this year, according to data compiled by Bloomberg. It has returned more than 10 percent so far this year.

Then there's the DDJ Opportunistic High Yield Fund, which has gained 9.8 percent, better than 99 percent of its peers. As of earlier this year it had more than 60 percent of its fund in debt with CCC or lower ratings by Moody's Investors Service, data compiled by Bloomberg show.

The Loomis Sayles High Income Fund, which is up 7.5 percent so far this year, has also been allocating more money to corporate shares, albeit on a much lower scale than the Fidelity fund. 

There is nothing inherently untoward about this trend. But the implications are significant. First of all, it suggests that even fund managers who specialize in risky credit have been seeing less value there than in equities. There's some reason for this: Despite this year's U.S. stock rally, which has sent broad indexes to new records, speculative-grade debt has rallied even more, at least by one measure.

The extra yield that junk bonds pay over a similar measure on the S&P 500 index has steadily fallen, despite gains in both asset classes. Bond yields and prices move in opposite directions.

Meanwhile, the potential upside for bonds is limited, as ultimately you're just hoping the company repays its obligations. Stock investors, in contrast, ostensibly gain when corporate fortunes rise.

Second of all, this highlights the perverse incentives for fund managers to take as many risks as possible right now, despite what are widely thought to be historically high valuations. Fund managers are increasingly using up their cash cushions as they seek to deliver the biggest returns, with the proportion of cash holdings falling to 4.7 percent this month, the lowest level in more than two years, according to the latest Bank of America Merrill Lynch fund manager survey.

While this is somewhat concerning, it's also logical. Fund managers don't see any imminent risks on the horizon that could shake markets (remember, even the threat of nuclear war hasn't really made a dent in recent rallies), and clients will penalize lower returns. 

Of course, over the long term, the consequences of this will be painful. It will tie the fates of high-yield bonds and stocks more closely, given that there's an increasing amount of overlap between the two. And it will create a disproportionate rout in the riskiest debt should there be a reason to sell.

It's fair to say the complacency of 2017 is setting the stage for a more painful downfall at some point. The longer this goes on, the greater the risk builds. But for now, apparently, party on.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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