Has the credit sell-off overshot?

Good morning. Markets were closed in the US yesterday, for Juneteenth, but European stocks rose and Bitcoin edged up, suggesting that risk appetites are stabilising after the bad week last week. We will see how those appetites hold up today, after the May existing home sales report and an earnings readout from home builder Lennar provide insight into the bleeding else of the US economy. Email us with your hopes and dreams: Robert.Armstrong and Ethan.Wu.

The freakout in corporate bonds

No one rings a bell when the market hits a low. This is an obvious point that is very hard to internalise. I traded the first half of the 2007-09 crisis brilliantly, going to cash early on. Then I missed almost half of the ensuing bull market, thinking for years that the recovery was a false dawn. I would have done better staying invested. Lesson learned.

This time around, intelligent individuals in the start or middle of their investing lives will do better than I did then, sticking to a sensible asset allocation, averaging in, rebalancing, and holding on. Professionals, tasked with outperforming the market, will try to adjust their allocations to the cycle, but know they can’t wait for that bell to ring.

A lot of pundits are arguing that the market is unlikely to rally until the Fed changes its posture. The central bank is in tighten till-the-data-gets-better mode, and no one knows where or when that is going to be. In the absence of a reliable estimate of where interest rates are headed, fear will keep the upper hand over greed.

In stocks, furthermore, we have not seen anything resembling the thorough renunciation of risk — capitulation, in market argot — that precedes a market bottom. But are things different in bonds? Consider this chart that Michael Hartnett’s strategy team at Bank of America published late last week:

Flows out of corporate bonds have been on the order of $200bn this year, as against net inflows for equities. That does look something like capitulation. Interestingly, this is not just a rote reaction to rising rates. Here are flows out of bank loan funds, which offer floating payouts, and have therefore been widely pitched as a good fit for the current environment. The air has gone out of that theory, fast, in recent weeks:

Is there a bond panic? Well, high-yield bonds’ spreads over Treasuries don’t say so, quite. Here are spreads for the highest and lowest rungs of junk credit, going back to the financial crisis:

Lots of people are increasingly convinced we are heading into a recession, but while spreads indicate that higher default rates are on the way, they remain well lower than in 2015-16 oil price crash, when heavy defaults were expected in the oil sector (which makes up 10-15 per cent of the high yield universe). In fact, spreads were higher at times in pre-pandemic late 2018.

One gets a slightly different picture, however, from the high-yield CDX index, which tracks (imperfectly) a basket of credit default swaps, that is, insurance-like derivative contracts that pay out when bonds default. This measure of default insurance costs has risen above those 15-16 highs:

The tricky issue here is that the CDX and the cash market often trade apart, because the CDX is easier to trade. It is more liquid than many bonds and requires a limited capital commitment. Higher CDX prices may reflect a strong interest in hedging or speculating — efforts to eliminate or bet on tail risks — rather than providing a clear barometer of default expectations.

Institutional bond desks can try to arbitrage the divergence between the CDX index and the cash bond market. For investors whose options are more plain vanilla, it is harder to express the view that the credit sell-off is overdone, and the risks to taking this view are higher than they have been in a long time, because inflation changes how bond markets act.

There are two basic kinds of bond risk: rising rates, and borrower default. The first risk is unusually opaque right now, because we don’t know how much the Fed will have to raise short-term rates to control inflation (at least I don’t). And at the current moment, miserably, if rates do rise more than expected, default rates will rise too, because the higher rates will mean the Fed is tightening us right into a recession.

If you accept that you don’t know the terminal rate of this Fed rate increase cycle, you have to accept that your default rate estimates aren’t going to be much good, either. This makes me think that the headlong rush out of corporate bond funds may indicate not capitulation, but rationality.

Consider a concrete example. The iShares high-yield bond ETF is yielding 5 per cent right now. The underlying bonds have an average maturity of about five years. Two-year Treasuries, with a bit less rate risk because of their shorter maturity and no credit risk at all, yield 3.2 per cent. Is the yield difference, in the shadow of recession, worth it? It could turn out that way. But given what we know now, the gap hardly seems to overstate the risks.

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