The performance of bonds, namely investment-grade and sovereign issues this year has been a key talking point for asset managers and investors around the world. If you didn’t enter 2016 owning investment-grade credit, it’s likely you’ve underperformed.

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Even though more than $13 trillion of credit is currently trading with a negative yield, investors continue to plough money into the sector seeking security and returns over yield in a low growth, uncertain world.

high yield paradise Could Turn Into A Nightmare: BAML

Analysis from UBS concludes that a year-to-date credit market returns have been a direct result of investment managers trying to catch up to benchmarks.

Number Of US High-Yield Defaults At Post-Crisis High

Analysis from the Swiss bank using data from eVestment, which covers both institutional and retail flows shows that there is a substantial divergence taking place in credit flows. Inflows are surging into global credit funds with little annual default risk (BB-rated and investment-grade credit) but for credit funds, with material default risk (lower than BB credit ratings) the data is showing outflows across all universes. What’s fascinating is that high-yield credit is rallying despite these outflows, an anomaly that in theory shouldn’t be taking place.

High-yield rally a result of…..

So why is high-yield rallying as outflows from the sector continue? UBS concludes that this anomaly is being driven by fund managers who are aggressively trying to catch up to benchmark allocations:

“The real force is coming from within. Underweight fund managers are aggressively truing up to benchmarks, having suffered the worst rate of underperformance since the Fed announced QE1 in 2009. Cash balances at HY bond and loan funds had surged heading into the year, but are now being depleted at the fastest rate since 2013. And anemic supply is also a factor. Global HY issuance is down 31-60% YTD for firms rated B and CCC respectively. Fund managers trying to add risk, for performance reasons, are not finding enough paper to buy.”

Only an average of 34% of HY bond and loan managers over the last three months beat their benchmarks.

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Bond market trend isn’t sustainable 

Clearly, this trend isn’t sustainable. Without new inflows, lower quality credit funds will eventually work through their cash balances and reach desired benchmark weights.

High-Yield Selloff Could Get Worse

According to UBS’s credit analysis team, high-yield CCC credit spreads are already pricing for a partial end to the default cycle, which is at odds with the team’s expectation that default rates will stay elevated in mid-2017 at 5% to 5.5%, with an uptick in ex-commodity defaults to 3% to 3.5%. However, an improvement in US growth, US earnings, a more dovish Fed or higher oil prices may result in the market’s lower default rate being a more accurate indication of the credit environment.

What does this all mean for high-yield in the near-term? UBS explains:

“On the positive side, fund manager cash balances (3.6%) are still above average, going back to 2009. There is more room for HY funds to deplete cash and tighten spreads further in the short-run (1-2 months). But obviously, this source of demand has its limits, as cash will eventually be whittled down and funds will reach desired risk levels. The lower quality echelons of US credit will need new inflows to continue this rally in the medium term (3-6 months). And this will require a further improvement in US growth because there is a fair amount of good news priced into markets today.”

“The ultimate irony of this is that any medium-term spread widening in the lower quality cohort from a lack of new inflows and issuance will eventually impact the high-quality bonds investors are piling into right now.”