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The Low Spark of High Yield Boys, Redux


High yield is approaching levels where the principal protection risk/reward has been maximized.


Flow of Funds Corporate Bond Assets

Of the major holders of corporate bonds it is the mutual fund accounts that have seen the most increase in corporate bond assets since 2008, however their share of Treasuries has also increased, presumably to meet the income demand from investors. Mutual fund flows also confirm this trend with taxable fixed income still receiving a vast majority of investor flow when compared to tax exempt or equities. According to ICI, in the past four weeks of the $27 billion in mutual fund flows, taxable bonds received $16.8 billion compared to a $1.3 billion and $81 million outflow of municipals and domestic equities respectively with the balance into foreign equities and hybrids.

The Fed isn't pushing investors into credit and equity risk by taking Treasury stock out of the market. This is a secular asset allocation shift by an aging population predicated on principal protection and the demand for income. This environment of falling inflation amidst this demand for yield is driving a reduction in the inflation premium embedded in the risk multiple which is manifesting in overall lower risk premiums.

Clearly high yield is leading this rally in risk but presumably we are in the late stages of this multiple compression as high yield approaches levels where the principal protection risk/reward has been maximized. This implied price cap not only raises the risk of investing in high yield but also other risk assets such as stocks that have been riding the coattails of risk premium compression.

In February of 2008 I wrote an article that was published on Safehaven titled the Low Spark of High-Yield Boys.The idea was that the falling Treasury yields were in danger of taking out the previous 2003 low at 3.35% and if so were signaling a much different economic reality than the market was prepared for and proof that the credit leveraging cycle had had turned.

We don't want to see the curve flatten in this low rate environment. It suggests the bond market is trying to stimulate the economy and that monetary policy is still too tight... If the curve flattens and the 10-year is pushing lower it is suggestive of much larger systemic problems. Housing would not be bottoming in this scenario and likely neither would the carnage in the securities they collateralize.

... Therefore, if yields get down to previous lows and actually continue lower while flattening the curve it will suggest the market and economy are in much worse shape and in need of a much lower cost of capital to generate positive returns. That equals a long term low return environment for all assets.

Today I get the same feeling that economic reality is about to trump the thirst for yield at any price. For high yield credit to trade rich to the growth rate of nominal GDP would truly be beyond the scope of even the most egregious financial irrationality. Price still matters at some level, and the closer risk yields get to the growth rate in the economy, the lower the margin for error when economic growth affects future cash flow those yields represent.

Twitter: @exantefactor
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