High Yield Bonds – The Canary in the Coal Mine?

The high yield bond market has shown continued weakness over the past six months.  As an example, take a look at the pricing chart below for HYG, a popular high yield bond ETF.  Part of the problem in the high yield bond market has been energy bonds, but it goes deeper than that.  We have talked about our concerns regarding the high yield market including its lack of liquidity, the few covenants that are associated with these bonds and the issuing corporations’ resultant increased debt leverage.  Is this the canary in the coal mine that is signaling more problems to come in the equity market?  Maybe!

There are several reasons why we think the high yield market has and might continue to drag down the equity market.  First, corporate debt has more than doubled over the past eight years as companies leverage up – many buying back shares to prop up their stock price.  This debt was issued at low interest rates and as these bonds mature, many companies will have to pay a higher rate to reissue the same debt, causing a direct hit to earnings.  Second, the high yield market is signaling that the economy may not be as strong as people think.  Interest rates are creeping up in the high yield market because investors are demanding a higher return for the increased risk of default due to the higher levels of debt – this is a red flag for the equity market.  Third, there are better return profiles than stocks these days.  Talking heads are touting stocks like JP Morgan given its 3% yield, but how does that compare to the high yield market with yields averaging 6-7%?  Better yet, yields on investments such as Master Limited Partnerships (MLPs) and Business Development Corporations (BDCs) currently are well over 10% with many more covenants in place than the high yield market.  Yields such as these provide direct competition for investment dollars and once people realize the relative value of these investments, they might sell off large company stocks and invest in these higher returning assets.

Portfolio Implications

We expect more swings in the market over the next several months.  There will be a time to get more aggressive, but we don’t think that time has arrived.  We continue to overweight alternatives and underweight equities with no direct exposure to high yield in the fixed income portion of the portfolios.