By Alan Gula, Chief Income Analyst
When we look back on this period in the financial markets, how will it be remembered?
Well, I believe that the last couple of years will largely be defined by the “reach for yield” and exuberance in the high-yield bond market.
It’s become common to dismiss the problems in high-yield land because they’re seemingly limited to the energy sector. However, the market is slowly going to realize that the high-yield debacle isn’t “contained.”
And last week, the junk bond market got a jolt.
Free Reports:
Get Our Free Metatrader 4 Indicators - Put Our Free MetaTrader 4 Custom Indicators on your charts when you join our Weekly Newsletter
Get our Weekly Commitment of Traders Reports - See where the biggest traders (Hedge Funds and Commercial Hedgers) are positioned in the futures markets on a weekly basis.
A Nasty Shock for Yield-Chasing Valeant Investors
As you probably know, shares of Valeant Pharmaceuticals International Inc. (VRX) got hammered last week when the company became the target of fraud allegations.
As for the company’s fixed-income offerings… the 6.125% bonds due in 2025 traded down to $83.50 on October 22. As recently as early August, those same bonds traded for more than $104.
The following table shows some of the largest U.S. high-yield issuers this year. Valeant actually tops the list.
It probably comes as a surprise to many Valeant equity traders and investors that the company has a sub-investment grade credit rating.
Now, Valeant may or may not default. But what’s clear is that the mispricing in the high-yield debt market allows companies like Valeant to lever up with impunity.
Equity shareholders are also complicit for having failed to punish companies with too much leverage.
Whether it’s a sharp decline in oil prices, corporate malfeasance, an economic downturn, or some other unforeseen event, the risks that may cause a default are manifold.
And these risks pose an even greater threat to investors in highly-levered companies.
Nonetheless, investors are flooding back into junk bonds.
Like Lambs to the Slaughter
So far in October, the SPDR Barclays High Yield Bond ETF (JNK) and the iShares iBoxx High Yield Corporate Bond ETF (HYG) have experienced inflows of $2.1 billion and $1.7 billion, respectively.
According to Lipper, high-yield funds saw their largest weekly inflow since October 2011 this month.
As you can tell, the herd mentality driving the reach for yield lives on. Like lambs to the slaughter…
The energy sector was simply the first to get hit, but now the credit cycle has turned. In other words, credit availability is starting to dry up.
Before it’s all said and done, every sector’s high yield bonds will be a disaster. At that point, most high-yield bonds will actually be high yielding because the default rate will be shocking.
It will also be a time to load up on this risky segment of the fixed-income universe.
Unfortunately, that opportunity is still some way off yet.
Safe (and high-yield) investing,
Alan Gula, CFA
The post Valeant Woes Prove Dangers of “Reaching for Yield” appeared first on Wall Street Daily.
