It has been a tough year for junk bond funds, if not for junk bond spreads, which as we noted recently have shown impressive resilience and have solidly outperformed IG since the start of the year (largely thank to a scarcity in HY supply, and a deluge of IG bond issuance to fund a new M&A cycle as Goldman discussed last week).
Meanwhile, as junk has refused to sell off, junk bond funds have been far less lucky, and the constant stream of outflows that began before the start of 2018, hit a record 34 weeks of outflows at the start of July (it did however reverse last week, with a modest $0.5 inflow) prompting many to ask where is the high yield bid coming from?
To be sure, much of the negativity surrounding HY funds is the result of growing “late cycle” fears for credit (as discussed most recently last week), which according to Morgan Stanley will peak in just two months (and in December for stocks)…
… coupled with concerns about Trump’s global trade war.
Meanwhile, in a surprising development, even as junk bond spreads have failed to widen alongside their IG peers, investors are growing convinced it is only a matter of time before the junk bond market suffers an “event.”
But first, a quick trip down memory lane: investors will recall that immediately before and after the market VIXplosion on February 5, when countless vol ETFs imploded as a result of massive short gamma exposure to the VIX, one of the side effects was a surge in high yield ETF short interest as many were convinced that the vol-induced market shock would promptly slam junk bonds next. This is what JPMorgan wrote at the time:
Both HYG and JNK short interest are at their highs for the period we track data from, suggesting that institutional investor participation via shorting ETFs has contributed to the sell-off in recent weeks. This is similar to the rise in the short interest ratio on the largest investment grade corporate bond ETF, LQD, which has moved higher during the same period this year, albeit from very low levels.
To the surprise of many, this did not happen, however the lack of a HY crash appears to have only cemented the bearish bias, because fast forward 6 months to today, when according to the latest JPMorgan Flows and Liquidity data the short interest in Global HY ETFs as a % of outstanding shares, is on the verge of hitting 25%, and is by far the highest on record.
How should one read this peculiar divergence in the data: on one hand, the record HY shorts point to the risk of a sharp blow out in credit spreads in the coming weeks should risk-off sentiment return, if traders start selling ahead of the ECB’s QE end at the end of the year, if trade war escalates further and hits the high beta credit space, or alternatively, if oil and energy names – all heavily represented in the junk bond sector – tumble as a result of a drop in oil.
Alternatively, should a negative catalyst not emerge, the risk for the shorts is one of a historic squeeze, and one which also collapses spreads to record tights.
Needless to say, the first outcome is more concerning from a broader, market perspective. And while a move wider in spreads would not be catastrophic, it could still lead to a broad liquidation panic at the synthetic credit level, at which point the main risk becomes the underlying threat latent within all ETF products, first voiced by Howard Marks in March 2015: “what would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once?” This is how Marks answered his own question:
in theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.”
Of course, there is the very real possibility that “someone knows something”, and is putting on a massive short bet, even as the broader market refuses to budge. In any event, based on the record accumulation of junk bond ETF shorts, we may soon find out if Marks’ “worst case” scenario plays out as envisioned, and what exactly happens when everyone tries to sell a synthetic product that is far more liquid than its underlying constituents, especially during a market panic., or alternatively, a historic short squeeze.
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