Last week's Korean peace talks were a spectacular attention-grabber. Just a few months ago, a North Korean war was a horrifically real probability, but now we have a smiling and smartly-turned-out Kim Jong-un on camera shaking hands with world leaders. After something so shockingly unexpected, it seems apt to imagine that anything is indeed possible.
If we extend this thought to the bond market, we find an underlying truth when it comes to junk and yields.
I have underlined several times that while we did see volatility in the equity market in Q1'18, the bond market was numb to any market movements; while Treasuries were falling, junk bonds didn’t widen much compared to how they were trading at the beginning of the year. I regard this as rather odd behaviour. On more than one occasion, my colleagues and I have speculated that things would soon change. Now, however, I wonder whether this is the case at all.
Junk bond issuance has notably been falling since the beginning of the year as the cost of funding in USD has steadily risen. Although this phenomenon has kept investors out of trouble, it has also made them more and more hungry for yield, and for too long. This is why as soon as WeWork, the US shared office space company, said it wanted to issue $500 million of high yield bonds, we saw morale perk up and investors dive into the new issuance.
Although WeWork’s revenues rose sharply last year, its costs rose even faster. Because it has virtually no hard assets, it offers very little security to investors. Regardless, the company was able to raise $702m at a yield of 7.875% while the initial offering sought $500m with an indicative yield of between 7.75%-8%. In fixed income language, this means that although unprofitable, the company was able to raise more money than it had planned at a reasonable price.
To many, this would sounds like déjà vu. Last summer we saw Tesla raise $1.8bn, or $300m more than expected, at a yield of 5.3%. The issuance of that bond was extremely successful although many had warned against Tesla’s high leverage and weak balance sheet. Certainly , Tesla's business is complete different from that of WeWork, but it remains a great example of how the market is blind when it comes to yield.
Tesla suffered of a major repricing after Moody’s downgraded the company to B3, it continues to struggle in speeding up the production of its Model 3, and the fatal crash that occurred while testing its driver-assistance system triggered many negative headlines. The 2025 bonds are now pricing in the high 80s, offering approximately 7% yield
One might assume that while it is normal to take risks and fail, as intelligent individuals we wouldn’t commit the same mistakes twice. However, it seems that although there are plenty of alarming signals, the market is not willing to accept that things have changed; what might have been a great investment in the past might not be so now.
The high yield rally that we have seen since 2016 until now might not be viable in the next few years as the Federal Reserve steepens interest rate hikes and the cost of funding increases (as we explained a few weeks ago).
Sentiment in the high yield space, and particularly the corporate space, is supported by central bank rhetoric. Indeed, although the Fed has started with its tapering and plans to continue with interest rate steepening in the near future, there is always a reassuring message that if things don’t go as well as they should, the Fed will be always there to set the score straight.
A powerful example was given by the European Central Bank last week, as the market was fearing that the bank was about to start tapering its Corporate Sector Purchase Programme (CSSP) as the rate of purchases fell compared to the first quarter. However, ECB chief Mario Draghi pushed back against the “stealth taper” speculation and reinforced his message by saying that the ECB has “certain flexibility” and if it needed he wouldn’t hesitate to use it.
The reality is that investors don’t fear taking risks when central banks hold their hands and we will need some major event before we will see a sell-off within the fixed income space. The real question is what will it take in order to put weaker credits under stress if the 3% psychological level didn’t pose major risks for this asset class? Having the 10-yr Treasury trade with a yield of 3%, rather than 10 basis points less, doesn’t imply much change in terms of the cost of funding junk bonds, but how far Treasury yields have to rise in order to send a shockwave through the market remains a mystery.
It is true that Treasuries can be supported by counter-current forces such as a potential trade war, strong economic growth, and a weak equity market, but at this point it seems that the real yield level to fear is 4% as this would constitute an important change in the cost of funding for capital intensive companies and weaker emerging markets, which would in turn translate into a sell-off in the fixed income space.
At this point, fixed income investors should no longer beware the 3% psychological level, and since we are very far away from the 4% level they should look for external threats to the bond market. A much stronger USD can definitely be categorised as one of these threats as it would suddenly increase the cost of funding for corporates and countries that have a soft currency as their base currency and that have issued debt in USD.
In this case, deterioration of debt can happen fast and it would leave little room to manoeuvre to borrowers in a market where fundamentals are already shaking.
It is exactly at that moment that high-yield investors will look at their books and understand that it is never wise to undervalue leverage.