Things looked bad for high yield bonds in December, as measured by the iBoxx $ high-yield index. Back then, the constituent bonds traded at an average yield of 10.3%. By the end of April the index had rallied, reaching an average yield of 7.6%. As our treemap visualisation shows, the worst declines were concentrated in oil and mining company debt, and the recovery has mirrored the rebound in commodities this year.
However, the US high yield market has yet to regain the confidence of investors. In the second half of 2015, there were $45 billion of outflows from the top 30 junk bond mutual funds, a trend that continued in the first five months of 2016 which saw $15 billion of outflows. Inflows of $5 billion into junk bond ETFs so far this year aren’t enough to compensate for that.
Risky Finance visualisations allow us to see how this investor confidence was eroded. In particular, we can look at a histogram distribution of prices by issuer in the index. At the end of December, out of a total of 320 issuers, 29 of them had debt trading at an average price of less than 60 cents in the dollar and 22 were below 50 cents.
It turns out that this skewed price distribution was a good indicator of future default. Of the 60 cents-in-the-dollar issuers, 45% subsequently sought bankruptcy protection. For companies whose debt traded below 50 cents, the proportion is 55%. The defaults include companies such as Linn Energy and Peabody Coal. Other issuers whose debt plunged to similar levels are struggling to avoid default, such as Chesapeake Energy.
So in the light of these defaults, were the mutual fund outflows a rational response to the price declines or was it an overreaction? As a proportion of the broad high yield market, the impact of the defaults has been small. Of the issuers in the iBoxx index, $23 billion of bonds have been affected, which is 2.7% of the total index by notional amount.
Of course, last year no-one knew who would default. All they could see was that there were $54 billion of iBoxx high yield bonds trading below 60 cents, and $165 billion below 70 cents. All the big mutual funds had invested in the troubled oil or materials sectors to some degree. So investors in these funds headed for the exits, forcing money managers to sell a wider chunk of their portfolios to meet redemptions.
It’s the sort of thing that worries regulators. In a paper published in March, Federal Reserve economists Fang Cai, Song Han, Dan Li and Yi Li claimed to have found evidence for systematic herding among bond funds. By analysing a proprietary database of holdings compiled by Thomson Reuters, the authors showed that high yield bonds are more likely to be sold than bought en masse. This chimes with previous findings that bond mutual fund outflows are convex on the downside – in other words they accelerate when returns go negative.
Does the recent sell-off give any support to these findings? It’s hard to replicate the work of Cai et al because their dataset is so opaque. But there does seem to be asymmetry among investors. After all, having pulled $60 billion out of junk bond funds, investors haven’t reversed themselves and attempted to chase the rebound.
In fact the only reason that the rebound took place may be that new high yield issuance all but dried up, declining from a monthly average of $30 billion to a low of $3 billion in December before recovering in April, according to SIFMA. Once investor outflows slowed, funds needing to replace maturing securities would have to scour the secondary market for replacements, pushing up prices.
Regulators might now decide to listen to suggestions that investors need to pay for bond market liquidity (such as having discounts imposed for early redemptions), a move that would be fiercely resisted by the fund industry.