Are We About To Witness A Reinvigorated Hunt For Yield? One Bank Says Yes
Last summer, Carl Icahn had a bit of “good natured” fun at Larry Fink’s expense at CNBC’s Delivering Alpha conference.
BlackRock, Icahn told Fink, is a “dangerous company.” The billionaire’s contention, in a nutshell, is that BlackRock is pyramiding systemic risk by funneling billions upon billions of dollars into corners of the bond market where liquidity is lacking.
The argument is fairly straightforward although you’ll find plenty of people who make it sound complicated. Dealer inventories shrank dramatically in the post-crisis world as the Street attempted to cope with new (and probably misguided) regulations designed to head off risk. Meanwhile, the Fed-driven hunt for yield and the increasing availability of new trading vehicles that allow inexperienced investors to pile into esoteric fixed income has created a situation akin to the crowded theatre analogy; only in our example the door (represented by dealer inventories) is shrinking while the theatre continues to fill up. Here’s what this looks like via Citi:
If someone were to yell “fire” (for instance if the entirety of the US shale complex goes bankrupt as the Saudis, the Russians, the Iranians, and everyone else keep pumping), there would be enormous selling pressure for a number of ETFs and if the Street isn’t willing to take on the risk by performing its traditional middleman function, a fire sale ensues in the secondary market. Mom and pop would be completely caught off guard.
That, Icahn contends, is why BlackRock and other issuers are “dangerous” in the current environment.
With that as the backdrop, Goldman is out with an interesting note to kick off the week. Essentially, the bank says that nearly everyone was caught wrong footed in February after coming into the year scared to death. Here’s what I said earlier today:
Part of the reason why January was such a harrowing month for stocks [was that] investors seemed to be concerned that oil - which fell to $27 at one point - was contributing to central banks’ inability to get things moving again and that the monetary gods were about to run completely out of ammunition.
Meanwhile, traders were also becoming increasingly concerned that the high yield market might simply implode should a wave of bankruptcies in the US shale space trigger a rush to the exits into a thin secondary market where, thanks to the post-crisis regulatory regime, Wall Street might no longer be willing to take inventory onto its books in a pinch.
Goldman notes that “90% of actively managed HY funds have underperformed their benchmarks year-to- date.” Why? Precisely because of the skittishness described above. Here’s Goldman again:
Key to the underperformance was the defensive positioning of HY funds heading into the year, maintaining high cash balances and low conviction as oil, recession, and redemption fears pulsated through the credit markets. However, the defensive strategy left funds underinvested when the HY and oil market sharply turned a corner in tandem in mid-February. To emphasize the velocity of the risk reversal, the HY market erased the nearly 200bp of widening in all of 2015 in just one month following the market’s trough on February 11th.
You can see this in a YTD chart of HYG:
The problem, as Goldman goes on to detail, is that it’s nearly impossible to trade this kind of vol given the lack of liquidity outlined above. “In aggregate, the decline in market depth and liquidity has served as a double-edged sword for actively managed funds, not only exacerbating volatility, but also hampering investors’ ability to scale in and out of positions efficiently when a choppy market requires it,” the bank writes.
What does this mean? For Goldman it means a reinvigorated quest for yield as managers desperately seek to make up for an abysmal start to the year by climbing further down the quality ladder to escape a high grade market where the amount of debt trading above 5% has fallen a rather remarkable 86% since mid-February.
The takeaways: 1) expect Bs and CCCs to tighten - and this trend should, if you believe Goldman, be even more pronounced than it otherwise would have been thanks to the ECB’s foray into corporate credit, and 2) a renewal of the dynamic that some say is creating the conditions for a collapse of HY.
Of course then again, if this year has taught us anything it’s that just when everyone zigs, the market promptly zags so take it all with a grain of salt.