“The primary, direct driver of default rates is not the yield on Treasury bonds but rather the business cycle.”
Martin Fridson, CFA
CIO of Lehmann, Livian, Fridson Advisors, LLC
At a conference in Chicago this week, following up on last week’s letter, Keep Dancing but with a Sharp Eye on the Tea Leaves, an advisor client asked me what my favorite “tea leaf” might be. When one of the greatest investors of our time, Ray Dalio, tells us to keep an eye on the exit door we should take note. But how? And when? There is no perfect indicator, but there are a few very good ones and it’s been my experience that simple is best and trend following works well.
Since we were talking about the economy and the stock market and since all the bad stuff in the stock market happens during recessions, my answer was to watch the trend in the high yield bond market. The players have a keen eye toward the economy and potential default risks in the bonds they own. Thus, in my view, high yield tends to be a pretty good “tea leaf.”
Watching the trends every day since the early 1990s has taught me that the high yield market generally leads the equity market by six months or so. It’s not exact, but in my 25 years of trading high yield, it’s been my observation (with real money on the line) that high yield is sensitive to the economy and tends to lead equities lower. I believe it is because high yield bond managers are razor-focused on changes in their underlying bond credits (default risks) and react just a bit faster than equity investors. More sellers than buyers drive prices lower.
So how can you keep your eye on this? Following is a weekly chart of the PIMCO High Yield Fund going back 19 years to 1998. The chart shows weekly price data. The orange line is a simple 13-week smoothed moving average price trend line. When the current price drops below the smoothed trend line, a sell signal is triggered.
I remember taking a lot of heat from clients in 1999. High yield rolled over in 1998 while the tech bubble bubbled on. Then it broke. Avoided were the recessions in 1991, 2000-02 and 2008-09.
Here is the chart and how to read it:
- The data is weekly price data for the PIMCO High Yield Fund (PHIYX).
- The orange line is the 13-week moving average line. Think of it as a smoothed moving average of the trend in price over the preceding 13 weeks.
- When the price drops below its trend line, that’s a warning signal (red arrows).
- When the price moves above the trend line, it is a buy signal (green arrows).
- Note – arrows show only a few of the signals to give you a sense of how it works. More attention should be paid late in a business cycle (like today).
It’s important for me to say that we use a trend following process that triggers more quickly than the above for our high yield trading, but the point is that trend following can help you gauge turning points in the economy and the stock market. High yield is a leading indicator for both the economy and for equities. Experience has taught me it is a tea leaf worth watching. Of course, past performance does not predict, indicate or guarantee future results.
PJ Grzywacz, CMG’s president, sent me the following Economist article a few weeks ago. “Alarm grows about over-exuberance in corporate lending.” Here is the bottom line, the chase for yield has led to really junky junk bonds. Remember those mortgage pools, subprime, CDOs and slices and dices of synthetically packaged AAA-rated garbage. Well, it’s happening again.
Investors are willing to accept such terms because they are desperate to earn some kind of yield on their assets. In the past eight years, central banks in developed economies have pushed interest rates close to zero. Government bond yields have also been at historic lows and some have even been negative.
When low-risk assets offer a poor return, investors are willing to take more of a chance. At times like this, Wall Street always has a suitable set of initials to flog. This time, it is the collateralized loan obligation (CLO), which bundles loans together into a diversified portfolio. As with subprime mortgages a decade ago, these portfolios are then divided into different tranches to offer higher returns (at higher risk). CLO issuance so far this year is double the amount raised in the same period of 2016, according to Wells Fargo Bank.
The cycle has turned again. Analysis by Moody’s, a ratings agency, shows that the proportion of the loan market that is “covenant-lite” has risen from 27% in 2015 to more than two-thirds in the first quarter of this year (see chart). Some loans even contain restrictions on the lender, not just the borrower.
The good news is that any shakeout in the market should be more contained than it was in the days of Bear Stearns and Lehman Brothers, whose collapse precipitated the 2008 crisis. The financial system is not as fragile as it was a decade ago; banks have more capital and are probably carrying less of this speculative debt on their own balance sheets.
Nevertheless, it is hard to escape the feeling that the market is being kept aloft by the actions of central banks.
So the risk is building. This from Investing.com:
According to Moody’s Covenant Quality Index, US and Canadian bonds issued during the month of June had a quality rating of 4.48, weakening from 4.26 in May and only four basis points of the record worst 4.52 set in August 2015.
SB here: 1 is best rating quality, 5 is the worst.
Further, ““HY-Lite bonds represented a record 60% of June’s single month issuance and a record 47% of bonds included in the June Covenant Quality Index.”
SB again: Big appetite for the riskiest bonds.
Tea leaves indeed. Keep the high yield price trend on your radar. For now, the trend is higher, so breathe easy and carry on. As you’ll see when you click through to Trade Signals (link below), the equity and bond market trend indicators remain bullish as well.
This week’s post is short. I hope you find the charts I share with you interesting. Grab a coffee, jump in and have an outstanding weekend.
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Included in this week’s On My Radar:
- Charts of the Week
- Trade Signals — Cyclical Bull Trend Persists