Monday, December 14, 2015

Junk Bond Risk Leading To A Potential 'Blood In The Streets' Environment

Investor attention at the end of last week's trading was focused on the sharp sell off in high yield bonds, better know as junk bonds. This sell off was precipitated by the firm, Third Avenue, restricting redemptions on its Focused Credit Fund. Subsequent to Third Avenue's announcement, Stone Lion Capital Partners L.P. said it suspended redemptions in its credit hedge funds due to the high level of redemption requests it has received. Many stories have been written about the events impacting the high yield bond market, here and here

In reality, a better classification for the Third Avenue Focused Credit Fund is probably a distressed debt fund or special situation fund. The fund's "focused credit" reference means just that, the fund is highly concentrated with nearly 30% of the fund's assets invested in its top 10 bond holdings. In other words, the fund is not a diversified bond fund. Our clients know we eliminated our high yield bond exposure in July of 2014. One reason we sold the high yield exposure last year was due to the narrow spreads on high yield broadly as reflected by the red dot in the below chart. This tight spread characteristic is an indication of the rich valuation of the high yield asset class at that time.

From The Blog of HORAN Capital Advisors

The issues surrounding high yield are being felt in the equity market as high yield bonds and stocks are highly correlated. Last week the Nasdaq declined 4.1% with the S&P 500 Index and the Dow Jones Industrial Average both declining 3.8% and 3.3%, respectively. For the year both the Dow and S&P 500 Index are essentially flat for the year on a total return basis while the Nasdaq remains up a little over 4.0% year to date. On a price only basis the S&P 500 Index is down 5.6% from its high in May.

The pullback last week has resulted in the CBOE Equity Put Call Ratio spiking higher to .92 as can be seen in the chart below. As I have noted in earlier posts, P/C ratios over 1.0 are representative of an oversold market. The second chart shows the VIX index and this fear measure has also jumped higher to 24.4. Readers can track these fear measures here.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

One near term concern we discussed in a mid-November post was the fact the On Balance Volume indicator (OBV) continued to show more trading volume on down days than on up days. This has been the case all year and has resulted in a downward sloping trend for the OBV a noted by the second white line in the below chart. From a positive perspective some technical indicators are beginning to look more favorable (CBOE P/C ratio noted earlier), but also indicators like the Full Stochastic Indicator below.

From The Blog of HORAN Capital Advisors

The risk developing in the junk bond market is a consequence of the Fed's extended near zero interest rate policy and investors feeling the need to reach for yield. Similar challenges have developed in the energy Master Limited Partnership (MLP) space. The belief is the Fed desires to begin removing the proverbial bunch bowl and raise interest rates at the conclusion of next week's Fed meeting. I suppose it is possible the recent issues facing the bond market could result in the rate increase being pushed into early next year.

Many of the headlines over the weekend were bearish ones with valid concerns about the high yield bond issues spreading into other areas of the market. On the other hand, this week's Barron's cover story highlighted 2016 forecast by ten strategists and all ten predicted higher equity returns for next year, with the average equaling 10%. With the issues facing the high yield bond market and a potential Fed rate hike around the corner, higher volatility in equities could face investors as the year nears its end. If this volatility is on the downside, Baron Rothschild, a member of the Rothschild banking family, is created with saying, "Buy when there’s blood in the streets, even if the blood is your own."

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