The fixed income market can be hit by a perfect storm
The corporate bond markets, on both sides of the Atlantic, has been hit this week by a wave of declines. As a result, we saw high yield bond markets and also investment grade bond markets falling from the record levels reached weeks before. The US high yield bond index, one of the most important benchmark of the junk bonds issued by the US companies, plunged sharply this week at 103.9 after it has peaked at record levels in May of this year, at around 113.7. The high yield bond market rally has last since January of 2009 because of the cheap money printed by the FED. These capitals have been poured into this market, by investors hungry for decent returns for their investments. In a very low interest rates environment, the high yield bonds have given to investors returns they couldn’t dream otherwise. Investors not only have made good returns on the higher coupons, but have also seen raising the value of their bonds, cashing some very good capital gains on the price differences.
Over the same period, defaults haven’t been a big problem for these risk taking managers, as the default rate has been very low, mostly lower than 2% in the last 5 years. But the tightening monetary policy, that already the FED started, is not a good news for these high yield funds and high return hunters. This week we saw $13 BN of outflows from the high yield funds in the US. Two of them, has been forced to halt investors from their right to redeem their quotes. Already, a downward spiral in the junk bond prices is opened. This downward revision of the sector by analysts depends also on the deep crisis of many companies that operate in the mining and energy sector. These two sectors represent almost 30% of the overall US junk bond markets. The commodity and energy prices have been falling deeply and companies have seen their share and bond prices slumping and the related credit default swap prices jumping.
From our point of view, the high yield bonds are “the short of a lifetime”. In terms of determining whether a break-point has been reached on the corporate high yield market we are going to watch the government bond market. Many analyst talk about a huge bubble in the fixed income market. We don’t think there are the conditions to expect a huge drop on these security prices, because the rates will continue to remain relatively low the next two years. The global growth remains still fragile and the monetary policy will be very prudent. However, we expect the Us high yield bond index to drop at least another 10% next year, as the Smart Money, the Hedge Funds and the High Frequency Trading will try to create volatility, accelerating the downward process.