Dec 15/15 – Taking the road less traveled
2015-12-15 11am EDT | #energy #high yield
Lately the financial press has been filled with stories about the terrible performance of high yield bonds. With worries about funds being gated and the continued terrible price action, the selling has only accelerated in the past couple of days.
And although investors are pitching their high yield bond fund holdings at a fierce rate, they are not nearly as concerned about their equity positions. In fact, even as high yield credit blows out to new wide spread levels for this latest move, yesterday afternoon stocks put in a bottom, and are now rallying strongly.
This morning the S&P 500 is opening up another 22 handles higher as the risk on rally accelerates. But I think investors are doing it wrong, and instead of chasing equities, they should be buying high yield.
This recommendation doesn’t get a lot of sympathy. Most investors don’t want to own something that is going down. It takes courage to step in front of this avalanche of selling, and as a group, investors have no courage.
This decline is made all the worse by memories of the 2008 credit crisis. Now that the tide has gone out on high yield bonds, comparisons to the previous credit crisis are filling investors’ inboxes. When you have a look at these sorts of charts, it is easy to fall prey to the mindset you better sell before the market blows up like 2008.
But the previous credit crisis was an aberration. You should’t expect a repeat of 2008. Not to say we can’t have problems in the credit markets, but that should not be the base case.
Most importantly, there is little chance this divergence between equities and high yield can continue indefinitely. Eventually either equities will follow credit down, or high yield will get up off the mat (or maybe a little of both?).
Yet we are approaching year end, and money managers are loathe to be heroes. Why show an overweighting in the worst performing asset classes? In fact, it’s probably best to just take these positions right off the sheets.
So we are getting selling in high yield credit, commodities and all the other dogs. And in the mean time, these “great” investors chase supposedly safe equities higher.
This offers an opportunity for those willing to take the road less traveled. I am buying high yield credit and shorting stocks against it. Obviously position sizing is important as they have very different volatilities, but I believe high yield credit hit panic lows yesterday that will hold in the coming weeks. And although stocks could rally into year end, I doubt we make new highs anytime soon.
Not only do I want to buy high yield, but I want to buy all the broken sectors. I want to be pick up the bonds investors are pitching in embarrassment. Even though this again goes against popular sentiment, I think the market is unduly punishing the losers of 2015. Energy names are at the top of my list. This graphic in an Irish business paper sums up the lopsided negativity towards energy:
Energy equities have been declining for quite some time. Take for example Chesapeake Energy:
The past couple of years the stock has been offered. Yet for the longest time, this weakness wasn’t making its way through to the bonds in any significant way. But then we reached the tipping point, and the bonds immediately went no bid:
This particular bond is trading with a yield to maturity of 60%! At these sorts of levels, suddenly bonds seem like a whole lot better way to speculate on the energy sector rebounding.
But instead of this decline in the price of the bonds attracting more investors’ interest, the lower price has only scared up more pink sell tickets.
For those selling their high yield funds because they are worried about exposure to energy and the other commodity names, they are doing nothing more than closing the barn door. A lot of the damage is already done, and the year end selling has only made it worse.
It is not time to puke out these positions, but instead those with a little bit of a stomach for risk, should be pulling out the blue tickets.
Thanks for reading,