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High-Yield Bonds Plus High Volatility Equals High Pain


Rising volatility could put a big hit on popular high-yield bond ETFs.

This article was originally posted on the Buzz & Banter where subscribers can follow over 30 professional traders as they share their ideas in real time. Want access to the Buzz plus unlimited market commentary? Click here to learn more about MVPRO+.

In late May, executives from JPMorgan (NYSE:JPM), Citigroup (NYSE:C), and Goldman Sachs (NYSE:GS), were complaining that it was all but impossible to make money in fixed income trading.

Between higher capital requirements thanks to Dodd-Frank and collapsing market volatility, revenues and returns were inadequate. Not surprisingly, these firms and others suggested cuts were coming.

As someone focused on confidence-driven decision making, the near industry-wide capitulation suggested that an upturn in volatility was near. Banks have historically cut resources to business units (and adding them for that matter) at precisely the wrong time. Like clockwork, the VIX  (INDEXCBOE:VIX) bottomed in early July at just over 10 and has not turned back since.

Over the past several weeks, as corporate credit spreads have widened and junk-backed ETFs like JNK (NYSEARCA:JNK) and HYG (NYSEARCA:HYG) have fallen significantly in value, the media and many market participants have commented on how the cutbacks in fixed income trading are adversely impacting the market. 

Even in the best of times, fixed income trading can be an invitation-only process, but liquidity is extremely thin and the growth in exchange traded credit-backed funds is only adding to supply as these vehicles are forced to downsize to meet investor redemptions.

While I would like to be positive in suggesting that rising liquidity will encourage investment banks to boost their market making operations, I can't be. Today's value at risk and capital adequacy models rely heavily on mathematical formulas in which market volatility plays a key role. 

Ironically, while banks just reduced their commitment to fixed income trading because of low market volatility, higher volatility could lead to even greater reductions in market liquidity as firms are forced to cut back trading positions in response to higher capital charges. Needless to say, if market volatility moves rapidly higher, there could easily be a vicious cycle in which rising volatility contributes to lower liquidity, leading to even higher volatility etc.

Whether such a vicious cycle develops will have a lot to do with how significant the peak in prices we have just experienced in high-yield credit is. As Bob Prechter points out, for investments, demand is always greatest at the peak in price. After a major peak, falling prices , rather than encouraging investors to get back in, actually discourage activity -- prices fall because demand is falling.

Should fixed income demand, particularly for high-yield credit, start to wane, the current dearth of market makers could easily cause prices to gap lower. Many ETF investors, who thought that exchange-traded products only move a little bit at a time, could be in for quite a shock. 

Already, the charts of HYG and JNK suggest caution.

To be clear, I don't have a dog in this hunt. Still, Wall Street's recent cutback to fixed income desks coupled with the post-crisis rise in credit-backed ETFs suggests that this segment of the market is one to watch closely. During a decline in confidence, the weakest always go first.
How high-yield debt handles a world of low liquidity will be an important tell.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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No positions in stocks mentioned.
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