As US junk bond yields crunch in below 4% for the first time despite the eye-watering pace of issuance, some investors are thinking about cutting their exposure to the asset class.
Average yields last week were at 3.97%, according to iBoxx data, while year-to-date new-issue volume was at US$74.5bn, well past the US$62.5bn seen in the same period in 2020, according to IFR data.
In Europe, the situation is similar: average euro yields on junk bonds were at 2.52% – tighter than pre-pandemic levels of around 2.8%. Yields in Europe were last this tight in the fourth quarter of 2017. Meanwhile, year-to-date issuance as of February 15 was at €15.81bn-equivalent – running over €2bn ahead of last year's €13.57bn-equivalent at the same stage.
Flows, though, are looking patchy in a sign of greater uncertainty ahead. After a record breaking year of inflows in 2020, US high-yield funds are seeing more volatile flows. The latest data (for the week ending February 17) showed outflows of US$1.347bn, according to Lipper. That was after a weekly net inflow of US$1.337bn earlier in the month, although that came after four straight weeks of outflows in January totaling US$3.69bn.
In Europe, the high-yield fund universe sustained its fourth consecutive week of net outflows, the latest weekly redemption being €354m, according to a JP Morgan report dated February 12.
Central bank action has distorted yields but with the pandemic far from over, many companies are now operating with more leverage than ever before.
Gross leverage had climbed to an average of six times by January, according to a recent Bank of America research report, up from just over four times in 2019.
"It feels like everyone is chasing yield, and unless it’s a credit that has deteriorated, like a cruise line, it’s just bid in too much," said Adam Coons, portfolio manager at Indianapolis-based Winthrop Capital Management. "We’re moving into equities as everything just feels rich.”
The situation is even more distorted in Double Bs, where so-called "tourists" – investment-grade investors dipping down into junk bonds to get returns – have helped squeeze in yields to 1.8% on bonds denominated in euros (back to pre-pandemic tights) and 3.2% in US dollar bonds.
This kind of additional flow into Double Bs may exacerbate any repricing, said Pilar Gomez-Bravo, director of European fixed income at MFS Investment Management.
Investors are becoming increasingly wary that any sign that central banks may start to slow down asset purchases could send the market spiralling.
The ECB is committed to its pandemic emergency purchase programme to at least the end of March 2022, though its policy statement last month was tilted slightly to the hawkish side over whether it will fully use the €1.85trn available to it.
Meanwhile in the US, Federal Reserve governors have quashed any talk of tapering asset purchases – the central bank is buying US$120bn of bonds a month. Fed chairman Jerome Powell recently pledged "patiently accommodative monetary policy" to get the US back to full employment.
Still, Gomez-Bravo said that MFS is considering putting on more hedges in high-yield and taking out market risk.
"We haven't started going down that path yet, but we're looking at it more closely," said Gomez-Bravo. "We're already being very selective: central bank action means that investors are being pushed to take more risk without understanding credit risk. That's where we're focusing now as we head into the second half of the year – if this rally continues, we will be more seriously considering taking exposure down."
MFS will be looking at whether the macro data support a mid-cycle recovery – or whether it looks like there is an asset bubble forming in high-yield debt, said Gomez-Bravo.
The biggest issue for high-yield in the second half of the year is if the market starts to worry that the Fed changes its monetary policy.
Rates markets are already lifting inflationary expectations, with the 10-year break-even rate (the difference between the yield on the 10-year Treasury and that on the 10-year Treasury Inflation-Protected Security) at 2.23%.
The latest annual core CPI data for January was at 1.4%, although with the vaccine programme against Covid-19 now being rolled out and economies expected to gradually reopen, the rate is expected to tick higher. So while the Fed seems to be more focused on growth and employment for the time being, its approach could change – which could mean a big swing in sentiment.
Still, US-based high-yield bankers in particular have been pointing to the spread level on US dollar high-yield bonds, which has tightened by 45bp in the year to-date to 341bp over Treasuries but remains wide of the post-financial crisis tight of 316bp seen in October 2018.
"Overall, the index is at a level that seems bordering on reckless and problematic, but notwithstanding the 10-year widening out the spread of that index is still not quite at all time tights," said one US high-yield banker. "Things are not as overheated as they seem.”
Investors are also asking: what else is there to buy in fixed-income, if not high-yield?
"I think bond investors right now are looking for the positives – and are looking for ways to stay comfortable with a rally that looks like it may be overheated," said the US-based banker.
"The high-yield investor base will have to get comfortable given the net inflows over the past year, which have been off the charts. If you're a portfolio manager, you have to buy stuff and find ways of making that cash work. On that basis, you can take the view that it is fine to take the risk of buying an LBO bond in an expanding economy where rates are likely to stay low because the Fed isn't going to do anything crazy."
* The eighth paragraph was changed to correct the location of Winthrop Capital Management
Corrected story: Corrects location of Winthrop Capital Management