This past month was a wild one for stocks, particularly in the growth-stock heavy NASDAQ 100. The index was down as much as over 5% as of May 12, before recovering a bit toward the end of that same week. Nevertheless, the remarkable rally the index has experienced from the lows set last March in the face of hopefully a once-in-a-lifetime global pandemic showed signs of coming to an end. The culprit for the shakiness was considerable worry about inflationary pressures caused by shortages and supply bottlenecks turning into corrosive inflation. The specter of 1970s style inflation hung heavy over stocks, with many market participants calling on the Federal Reserve to think about removing some of their tremendously accommodative monetary policy support sooner rather than later to head inflation off at the pass. Meanwhile, the Fed has been clear that they have not even begun to think about thinking about removing any accommodation in the near future. This has set up a great debate between the Fed and many notable investors and academics as to what should be done, if anything.
The one thing that everyone can agree on is that high and sustained levels of inflation are bad for many financial asset classes as well as a great majority of businesses and individuals. Moreover, the extraordinary monetary policy the major central banks have engaged upon for at least a decade has created the phenomenon of fixed income bonds and equities moving, often quite sharply, in the same direction. It might feel fantastic when everything goes up at the same time, but, conversely, it feels pretty awful when the opposite occurs. When that happened, as it did for part of last week, there is no place to hide.
With these troubling thoughts in mind, we wondered what was happening in credit-sensitive assets like high-yield bonds and loans. When the economy shut down last March, these asset classes were simply annihilated. Five-year high-yield bond prices, as measured by Markit CDX, went from a dollar price of $109 as of February 21, 2020, to $90.5 as of March 23, 2020. During the same time period, high-yield syndicated loans, as measured by the S&P/LSTA Leverage Loan Index, went from 96.67 on February 21, 2020, to 76.23 on March 23, 2020, a decline of 21%. The bottom was set on March 23, when the Federal Reserve and Treasury Department intervened massively in the financial markets. The Fed returned to their near-zero rate policy, launched never-before-seen in size quantitative easing that lowered long-term rates and a joint $250 billion liquidity programs for corporate debt, including support for “Fallen Angels” or companies like Ford Motor that were investment-grade (the top 4 ratings from either S&P or Moody’s), but were downgraded to “junk” after March 22, 2020. The result of these programs saw these assets, much like equities, roar back to pre-COVID and beyond levels.
Now, with the threat of inflation roiling the equity markets, it is interesting to see how high-yield bonds and loans are performing. Currently, the two markets are pretty steady. The Leveraged Loan Index actually rose slightly last week and is sitting right near its all-time highs. High-yield bonds, as measured by Markit CDX, fell a little more than a quarter of a point and sit near the all-time high set this past April. This seems a bit odd, given the rate and inflation backdrop. If the Fed intervenes earlier, as some market participants wish them to do, withdrawing monetary accommodation when the economy is still relatively weak and vulnerable will no doubt throw it back into recession. That is a bad outcome for high-yield corporate credit. If the Fed does not move to withdraw accommodation and the inflation bugs are right, then rates will go up a lot more a little later, and that will clobber the sector. The only scenario that supports current valuations is that if the Fed is correct, the price spikes we are witnessing are indeed transitory, and all will be well. The question is, is that the bet investors are making, or is it just a bit of deer in the headlights? Only time will tell on that.
The one thing we really have to reflect on is, why the Fed and Treasury had to implement their truly audacious $250 billion rescue package for corporate debt in the first place First, though, we should issue a bit of a caveat. Other than “Fallen Angels,” the actual program did not consider the rest of the high-yield bond and loan class. However, the psychological support the programs gave was tremendous In fact, as it turned out, the program gave the markets so much confidence that they barely had to buy anything at all. However, one of the main reasons the asset class was pulverized was due to a severe liquidity shortage. Moreover, while liquidity was a major problem for other asset classes, the situation for high-yield was, and remains, unique.
For years leading up to the COVID Spring, high-yield bonds and loans were whistling past the graveyard. Far too many bonds and loans were in investment vehicles such as open-end mutual funds and exchange-traded funds (ETFs). These instruments provide daily or, in an emergency, near-daily liquidity. For an open-end mutual fund, the fund manager can only suspend redemptions for seven calendar days. After that, the fund must petition the Securities and Exchange Commission (SEC). Up until last March, the SEC granted this request exactly seven times since 1970. The SEC rule 22e-4 limits the number of illiquid assets in a fund total no more than 15% of all assets in the fund. Illiquid is defined as an asset that cannot be sold in seven calendar days or less without a significant drop in market value. High-yield bond and loan funds were routinely classifying nearly all their high-yielding assets as liquid. However, it was a poorly kept secret that these assets could go from liquid to illiquid in a liquidity event. If that sounds like a “Catch 22” scenario, that’s because it is! When you read the prospectuses for these funds, their risk disclosure essentially tells potential investors that there is a real risk that if something like COVID happens, the fund won’t be able to meet redemptions on time, and the redemptions are exposed to material losses. Here is one popular high-yield loan fund’s risk warning disclosure:
“Liquidity risk may also refer to the risk that the Fund will not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, an unusually high volume of redemption requests or other reasons.“
That is pretty interesting as it appears the fund is disclosing a risk that they are not really even allowed to take! What happened in March 2020 was “Something like COVID” actually happened, investors wanted out, market makers for the assets in the funds hid under their desks, and a catastrophic run on the funds was about to take place. This was a risk that was always there if someone looked, but the most important somebodies, which includes the Fed, didn’t know or didn’t want to know. This is why the Fed and Treasury had to intervene so dramatically on March 23, 2020.
We know that, as these high-yield loans and bonds not only recovered back to their lofty pre-COVID levels but have actually surpassed them. We also understand that high-yield loans are supposed to offer protection against rising rates with their interest rates floating. However, the floating interest rate will be no match if either the Fed intervenes to snuff out inflation and causes a recession or the Fed is mistaken, lets inflation attach itself, and then has to chase the horse out of the barn with significantly higher interest rates as a result. Moreover, it is no secret that many of the companies in these asset classes are over-leveraged and have poor to very poor cash flow. Many are the so-called “Zombie Companies,” companies that after interest payments, have a net loss—or worse, companies that have a loss before they even can service their debt.
The same structural liquidity problems are still very alive and well, despite what the markets witnessed in the terrible early weeks of March 2020. Perhaps because no one was allowed to fail, banks, fund managers, and investors just went back to doing what they were doing. If the Fed picks either door number one, an earlier-than-planned tightening of policy, or door number two, runaway inflation, the very large high-yield corporate bond and loan markets are going to pay a heavy price, unless of course the Fed and Treasury bail them out again.
An index is unmanaged and not available for direct investment. Definitions sourced from Bloomberg.
- The Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value Index represents the portion of the Bloomberg Barclays Global Aggregate Index that measures the aggregate value of global debt with a negative yield.
- The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
- The NASDAQ Composite Index is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market. The index was developed with a base level of 100 as of February 5, 1971.
- The Cboe Volatility Index® (VIX) is a calculation designed to produce a measure of constant, 30-day expected volatility of the US stock market, derived from real-time, mid-quote prices of weekly S&P 500® Index (SPX) call and put options with a range of 23 to 37 days to expiration.
- The ICE BofA MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of implied volatilities on the CT2 (Current 2 Year Government Note), CT5 (Current 5 Year Government Note), CT10 (Current 10 Year Government Note), and CT30 (Current 30 Year Government Note), with weights 0.2/0.2/0.4/0.2 respectively.
- The Markit CDX North America Investment Grade Index is composed of 125 equally weighted credit default swaps on investment grade entities, distributed among 6 sub-indices: High Volatility, Consumer, Energy, Financial, Industrial, and Technology, Media & Tele-communications. Markit CDX indices roll every 6 months in March & September.
- The Markit CDX North America High Yield Index is composed of 100 non-investment grade entities, distributed among 2 sub-indices: B, BB. All entities are domiciled in North America. Markit CDX indices roll every 6 months in March & September.
- The U.S. Dollar Index (USDX) indicates the general international value of the USD. The USDX does this by averaging the exchange rates between the USD and major world currencies. Intercontinental Exchange (ICE) US computes this by using the rates supplied by some 500 banks.
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