JUNK SALE

If the high-yield bond market is the fixed-income equivalent of the fat lady singing, the diva appears to be yodeling. Just what she’s saying, and what it means for the markets is debatable, but there’s no doubt that there’s a whole lot of singing going on.


The yield on the KDP High Yield Daily Index has risen sharply over the last month. As of yesterday, this measure of yield for low-grade bonds touched 7.67%, the highest since June 2004. It was only in early March that the index was yielding around 6.5%–more or less the lowest in a generation.
A lot can change in a month, as suggested by the longest sustained rise in junk yields in nearly a year. Is this so-called early warning sign a reliable indicator of things to come in the price of money? Or is the lady singing for reasons that have little to do with the wider world beyond junk?
One reason for pausing before answering comes from the signals in the far-more influential 10-year Treasury Note, which is showing no comparable signs of stress of late. The benchmark government bond yields around 4.2%, and has been falling for much of the past month after reaching roughly 4.65% in late March.
In the wake of yesterday’s weaker-than-expected report on economic growth, it’s hardly a shock to learn that traders of government debt are in no rush to dump the securities. The slowdown implied by the first quarter GDP rise of 3.1%, down from 3.8% in the fourth quarter, is giving new life to the notion that Treasuries are again worth buying. The rationale is that interest rates will cease rising, if not start falling again, in the face of a slowing economy. Of course, that assumes that the Fed will ignore the growing inflation signals. But we digress.
In any case, who’s about to argue against the idea that the economy’s set to further slow? Certainly not the oil market, at least not today. A barrel of crude closed below $50 in New York today for the first time since February. The implication: marginal demand growth for energy is cooling, and that is easily reversed engineered to conclude that the economy’s slowing.
If that’s the accepted wisdom, is the junk market in agreement? Hard to say, although this is clear: junk yields are rising on a relative as well as absolute basis. The spread in high-yield debt over the 10-year Treasury is nearly 360 basis points, the highest since May 2004.
Is the divergence significant, or just an anomaly? Only time will tell, but in the meantime some pundits are reminding of the lessons imparted by history when it comes to junk yields. “Historically, the debt market, especially the high-yield market, has frequently served as an early warning signal for broader weakness in the capital markets,” Dun Yin, an analyst with high-yield-oriented broker/dealer CRT Capital Group, tells AP via BusinessWeek.
But hold on a minute. We learned today from the government that Joe Sixpack spent more in March than economists expected. What’s more, Joe earned more than the dismal science predicted. Certainly that takes off a bit of the gloom imparted in yesterday’s GDP report. What’s more, the personal spending and earnings news helped light a small fire on Wall Street, pushing the S&P 500 up by more than a percent.
So where does junk fit into all this? Maybe nowhere. It’s possible that the high yield market’s adjusting to ills of its own making. One economist who follows junk says the recent back-up in yields reflects trends specific to the market. “The recent corporate spread widening was precipitated by a handful of company-specific problems,” Dana Saporta, an economist at Stone & McCarthy Research, recently wrote in a report, according to Bloomberg News.
Indeed, some news stories circulating note that the presumed ongoing decline in the credit status of GM (it’s currently just one notch above junk) and other companies will soon dump an excess supply of low-grade debt on the market. That threat, runs the logic, is pushing down prices (and yields up) in anticipation of the future supply rush. “Profit warnings from the world’s top two auto groups, General Motors and Ford, have cast a pall over the high-yield credit markets,” says Jeremy Field of Credit Suisse in London, according to a recent story in the International Herald Tribune. “Both companies are teetering on the edge of investment grade, and investors are justifiably concerned about the impact of over $200 billion in debt entering the high-yield market. A blow-up in the auto sector will not just affect dollar bonds; it will reverberate across every credit market and currency.”
Junk bond investors are already feeling the reverberations, whatever the ultimate source. High-yield bond funds have reported net outflows of nearly $1 billion in the two weeks through April 27, reports AMG Data Services. That follows $4.3 billion of outflows from the sector in March.
But one veteran junk-bond watcher, Martin Fridson, who publishes Leverage World, dismisses this notion that this is all about anxieties over a coming supply wave. “Investors are overstating the potential impact of a GM downgrade,” he advised in a recent newsletter, AP reports. “Fears of the high-yield market being crushed by new supply of fallen-angel debt are not justified.”
Perhaps, but we’ll still be keeping a close eye on GM and Ford in the weeks ahead for any clues about which way the wind’s blowing, and which song the fat lady’s singing.