The Search for Yield: Part 2

In Part 1 of this series we analyzed economic data to see if the purchase of high-yield funds (in particular, loan participation funds) is justified, given current economic data. What we found was that economic data suggest a higher risk premium than that priced in today.

In this article we look at stock and bond market data for clues about whether to purchase high-yield funds.

In a recent article[1] Christopher Woods wrote that his target “for the correction on the S&P500 is now 1575, the 2007 high, or 17% below the recent peak.” This would be the biggest correction since 2011 when the S&P500 declined 22%. The main reason for this view, Woods writes, is that  breadth indicators have been deteriorating for the past several months as market leadership has progressively narrowed. Since May 2013 each successive new S&P500 high has been marked by lower breadth readings. To again quote Woods, “As students of technical analysis know, this is a sign of market deterioration and a pending ‘top,’ with the stock market having now seemingly lost its ‘leader’ in the form of the social media stocks. Recent prevailing market sentiment has also certainly fulfilled the characteristic of a top.” Woods’ comments are not unusual among technical analysts, and Woods is one of the keenest observers of U.S. markets and economy.

REUTERS/Mike Theiler

Woods further writes, “The Fed for now is continuing its tapering. While this does not represent tightening, it does represent a diminution in easing. The longer the Fed proceeds with tapering the more bearish implications it has for US equities, and indeed risk assets everywhere including those priced off credit spreads. On this point, the current multi-year low spread on so-called junk bonds in America makes no fundamental sense at all. Thus, the spread between the average yield on the Barclays US Corporate High Yield Index and US Treasury bond yields has fallen from 9.1% in October 2011 to 3.69%, the lowest level since July 2007.” So, here is the tie-in between equities and high-yield instruments. If Woods is right, the Fed’s continuing to tighten, which is indeed the Fed’s stated policy, may have a bearish impact on high-yield instruments.

As for what the bond market is indicating, we start with eurodollar futures. These futures are indicating that the market is not expecting the three-month Treasury rate to be at 1% until the end of 2015 and at 4% (the average rate over the past 30 years) until September 2020. In response to this expectation the eurodollar market sees a very high amount of shorts in place, signaling this market is indeed expecting rates to rise.

The long end of the yield curve is continuing its fall and is now at 2.55%. That is a decline of 45 basis points from its end-of-December 2013 high. This movement in the ten-year could be signaling that the bond market senses a deflationary environment is approaching.

This echoes a recent statement from the International Monetary Fund, which drew attention to the harm being caused by “stubbornly weak price increases” over the five years since the start of the financial crisis. The IMF is urging central banks all over the world to increase their efforts to coax inflation up.

The IMF is worried that low inflation will undermine the global recovery, in part because it makes debt too expensive to service. While a weaker currency is great for nations with high export income (since they can earn more of their own money when they sell their products), a weak currency is counterproductive for nations with enormous debt, since it requires more of the local currency to cover loan payments and interest. Clearly, if the long end of the curve is pricing in a deflation “premium,” the IMF’s warning about deflation’s impact on debt servicing will have a negative effect on holders of high yields.

In this article we have shown that the stock and bond markets, in particular the bond market, are pricing in a deflation threat. This would have a significant impact on high yields since it would mean debt becomes too expensive to service. So, similar to what U.S. economic data are showing, the bond market is starting to indicate there is a need for higher risk premia in high-yield bonds.

As to purchasers of loan participation and/or high-yield funds, it is time to be wary in terms of adding to current holdings.  And as to initial purchases of the same funds to an existing portfolio, bear in mind the risks delineated above.