High Yields as a False Signal
Pfäffikon SZ, Switzerland – The last several weeks I have been made aware of the ominous reports coming from the bond market. The underlying thought being that the bond market is quicker to respond to possible negative surprises than the stock market is. Last year, in their crazy pursuit of short-term returns, investors arrived at bonds with higher interest rates and a corresponding higher risk profile, also known as high yields. These investors in particular have not been feeling comfortable over the last several weeks.
Under Pressure
Now that high yields are under pressure many market researchers foresee significant market corrections on the stock markets. In my view this approach is premature and cuts too many corners. Timing the market is a difficult trade and can sometimes go hopelessly wrong. The low volumes in December are making the markets bounce in all directions, a situation where the wrong timing can lead to permanent losses. Meanwhile, high yield is under pressure, primarily due to the decrease in commodity prices. It now becomes interesting to ask ourselves how long these low commodity prices can be sustained now that research and development in the sector is being rapidly curtailed and growth in countries such as China, the US and the EU persists.
Liquidity
There is another factor that plays a role with high yield and that’s the limited liquidity of these loans. Liquidity is nothing more and nothing less than a psychological phenomenon. After all, the liquidity in these high yield loans has not changed in relation to a couple of months ago. Now that investors are hunting for offers that do not – or barely – exist, prices drop more than is justified and the signal to the market overshoots. It’s worth mentioning that some bond ETFs are being traded as water when the underlying loan barely has any liquidity. The gentlemen call this “transcendent liquidity”, but in reality this is nothing more than an ordinary shell with a thin layer of chrome. This is a highly unhealthy and undesirable market development and in my view food for the regulators.
Duration
The true problem in high yields is their duration. Between 2018 and 2022 a staggering amount of high yield loans will expire, which need to be rolled over. In principle this is a problem that you should wait for the end of 2016 to put in your diary. After all, now that the playing field in bonds is about to change, investors are getting nervous. But issuers are also starting to scratch their heads now that the era of free money seems to slowly be coming to an end and new conditions have become uncertain.
Quality
High yield generates another signal for investors. The time when the rising tide floated all boats, including the leaky ones, is over. Concretely this means that investors have arrived at the point where they need to start selecting for pure quality now that the bull market is coming of age. It is a fallacy that the stock price of a quality share cannot drop. Even quality shares get punished during when prices drop, but he who carefully does his homework and checks off his checklist can do excellent business and achieve large discounts in relation to intrinsic value. Even at this time there are many attractive opportunities available based on this approach.
It is remarkable that many indicators and charts which we follow on a weekly basis have not sent off any warning signals, especially not within the reach of bonds. Admittedly, these signals are under pressure, but they are not showing anything different from the beginning of the year. It is also worth noting that some investors tie incorrect conclusions to macrodata coming from, for instance, China and the US. For long-term investors these shifts are less relevant and it’s more about positioning. The emitted signal by high yield bonds so far seems to be a storm in a teacup.
It remains for me to wish you a good weekend.
Jan Dwarshuis is a senior asset manager at Thirteen Asset Management AG, where he is responsible for the Thirteen Diversified Fund. Dwarshuis writes his columns in a personal capacity and is not paid for them. Nor is he paying for his columns to be placed. Professionally, he holds positions in major European, American and Russian stock funds. The information in his columns is not intended as professional investment advice or a recommendation to make certain investments. At the time of writing, he has no position in the above mentioned shares and has no intention of doing so in the next 72 hours.
