The hunt for yield narrative that directed the flow of capital within levered credit markets in November, December and much of January, had powerful implications for market prices. As has been well documented, “high” yield bonds now yield, on average, less than 4% for the first time in their history. Hurdle rates that compensate investors for owning CCC-rated bonds, the junkiest cohort of the junk bond market, have compressed from 9-10% in October to sub-6.25% on average, with several credits on the right side of that distribution yielding as low as 4.5% to 5.5%. The market distressed ratio, the percentage of the $1.5 trillion high yield bond market that trades with a spread wide of 1,000 basis points (bps), has collapsed to a six-year low. And market dispersion, a measure of the percentage of high yield bonds that trade at a spread that is at least +/-100 bps from the market average, has also collapsed to levels not seen since September 2018, before the Q4’18 sell-off. Words don’t fully capture the extremes at which market prices currently sit. Let’s take a look at some pictures instead:

Junk Bond Yields at Historical Lows

Source: Bloomberg, Barclays

CCC Hurdle Rates Compressed to Historically Unsustainable Levels

Source: Bloomberg, Barclays

Distressed Ratio Indicating Near-Zero Concern for Default Risk

Source: Credit Suisse

Collapse in Dispersion: Just 55% of High Yield Bonds Trade at a Spread Outside +/-100 bps of the Market Average

Source: Bank of America

As we progressed through January and into February, a subtle handoff appears to have taken place in the technical undercurrent to the marketplace. Perhaps, less of a handoff as an expansion. The hunt for yield is seemingly now just one expression of this encompassing theme, and arguably a less and less powerful expression given the now paltry yields on offer in the marketplace. We are instead observing a wholesale (indiscriminate) bid for positive convexity. Let us expand. Approximately 75% of high yield bonds embed a call option whereby borrowers have the right to pay back, or call, their bonds at a pre-determined schedule (normally after a certain number of years at a modest premium to par). Lenders are short this option, i.e. they “sold” this embedded option to the borrower at issuance. Currently, 80% of this universe of “callable” bonds trade at a price above their next call price. In a mathematical sense, that embedded option the bondholder is short is now further “in the money” and for every incremental basis point of yield compression, the resulting appreciation in the price of the bond is less pronounced, i.e. the bond is negatively convex. In a practical sense, the total return potential of the security has diminished and prospective returns are at worst some 1-3% type IRR to the next call date or at best some incremental return to a longer takeout (to the extent the borrower’s CFO elects not to exercise their option).

At the same time the high yield asset class has become increasingly negatively convex, the near-term consensus thesis in the marketplace is unambiguously, acutely and overwhelmingly in favor of reflation – coordinated fiscal and monetary stimulus concurrent with an economic recovery. Concentrating in reflationary (or positively convex) assets is a rational response to a reflationary thesis. Record inflows into equities (the ultimate positively convex asset) is, in part, a case in point. Within the negatively convex high yield bond market, how is this being expressed?

1. Discount is evaporating from the marketplace – less than 2% of the marketplace now trades at a dollar price below $90. Less than 1% trades below $80. Only 22 cusips…CUSIPS…trade at a price below $70. Any and all remaining discount (positive convexity) is being bid away by investors. Many, if not all, of these credits carry CCC ratings, hence contributing to the compression in CCC hurdle rates.
2. Newly issued par bonds are aggressively bid in secondary trading – at issuance, callable bonds have greater convexity as the embedded option remains “out of the money.” Borrowers have responded to almost euphoric demand for new par bonds with a record pace of issuance in 2021. Of note, four new issues in the first four days of February were bid approximately four points higher (to +/-$104) within the first few hours of trading as investors indiscriminately priced away the convexity.
3. Event “optionality” is priced to perfection – certain investments embed options or opportunities for total return upside via any number of catalysts (M&A, ratings upgrades, document arbitrage, etc.). That “optionality” can be cheap or expensive as a result of what’s implied by market prices. In recent weeks, the non-callable (and therefore positively convex) bonds of two high quality borrowers, Kraft and HCA, were bid up aggressively as investors coalesced around a thesis the ratings agencies will upgrade these borrowers from high yield to investment grade. While recent fundamental events have indeed increased the probability and accelerated the timing of a potential upgrade (at least in the case of Kraft), the speed at which investors re-priced the bonds and the certainty of the event now implied by market prices is of note.

Indeed, any whiff of positive convexity is immediately priced away in today’s market. How is TCW navigating these waters? From a top-down perspective, we appreciate two prevailing realities. First, the market is seemingly all-in on the reflation thesis (and the Fed’s ability to suppress volatility). While this may prove right, more important is the fact market prices and investor behavior don’t appear to even consider it might prove wrong. Everybody to the right side of the boat as it were. Second, positive convexity is becoming very expensive. That being said, we are credit pickers. While the opportunity set of discount bonds has dwindled, we are picking our spots, capturing that positive convexity as compensation for the inherent risks we are underwriting. We don’t own many CCC-rated credits as the hurdle rates on offer historically have proven too low for the risks. Maybe this time is different? At a time when demand for new issues is seemingly indiscriminate, we have become extremely discerning. Again, picking our spots where the risk/reward makes sense (the incremental convexity is an added bonus). Finally, underwriting embedded “optionality” is a core competency of TCW’s credit team; however, part of that competency is an ability to identify when options are cheap and appreciate when they have become expensive. We continue to emphasize cheap optionality in portfolios and de-emphasize expensive optionality.

Market Performance

High yield bonds gained in January, though the performance in the aggregate was meager. A modest intra-month “dip” in prices for high quality bonds, coupled with the reality of an increasingly negatively convex backdrop, held total return to just +0.33%. Supply technicals also pushed back against the general reflationary undercurrent with a record month of issuance (discussed below).

Still, heavy supply and interest-rate-induced volatility were not enough to dampen the momentum in lower quality, higher convexity bonds. CCC-rated bonds returned +1.48% for the month and distressed credits (those rated Ca and below) returned +6.82%. This compares to the returns of higher rated BB and Single-B bonds of +0.06% and +0.19%, respectively. As discussed above, the hunt for yield / hunt for convexity bid for reflationary assets has resulted in robust returns for CCC-rated debt over the past three months.

Source: Bloomberg, Barclays

Notable Outperformance of CCC-Rated Debt Since November

Source: Bloomberg, Barclays

Oil Field Services, Independent E&P and Airline bonds were the top gainers for the third month in a row. E&Ps and Airlines offer a nominal yield pick-up to the market, and hence benefit from the bid for yield. Oil Field Services bonds, on the other hand, sit perfectly at the nexus of high yields and large discounts offering the requisite convexity for reflation-centric investors, seemingly regardless of fundamental quality.

Source: Bloomberg, Barclays

Market Technicals

Fund flows took a pause in January after $47bn in capital flowed into the asset class last year (over $70bn from March 23rd to December 31st). Modest outflows of -$340mn during the month were the result of redemptions from ETFs, most likely by large institutional money managers that used the proceeds to fund investments in newly issued bonds. It is not entirely clear that was the driver, but the shoe fits at least. We continue to monitor daily fund flows of high yield and leverage loan retail funds for signs of a possible inflection amid evolving sentiment around the path for interest rates.

ETF-to-New Issue Rotation is Likely Behind the Headline Net Outflow in January

Source: Credit Suisse, EPFR

The borrowing binge, as it were, extended into the new year with January primary volume coming in just behind the monthly record set this past summer. Over $52bn in USD-denominated debt was issued in January. The busiest January ever (and the second busiest month behind June 2020). Year-to-date through mid-February, over $70bn of new issue has cleared the market, the most active start to any year in the history of the high yield market. Simply put, demand begets supply and while we put forward a thesis as to what’s driving that demand, the implications are unparalleled (and in a growing number of cases, imprudent) borrower access to capital.

Fundamental Trends

Reflexivity is bidirectional and in today’s market the feedback loop is working relentlessly in the borrower’s favor. Borrowers facing financial distress are availing themselves of a myriad of avenues to accumulate fresh liquidity, which in-turn is alleviating said financial distress, which in-turn is opening up incremental pockets of liquidity, and so on…reflexivity. Whether it be AMC’s “at-the-market” equity raises or the regular way secured and unsecured issuance by NGL or Bristow or Party City or Chesapeake, accommodative (borderline euphoric) capital markets are availing liquidity to even the most marginal of credits. Therefore, it is not surprising that during the month of January zero high yield and leverage loan borrowers defaulted on their obligations. Zero. As highlighted above, the market distressed ratio is at a six-year low, portending de minimis default activity at least over the very near horizon.

Zero Borrowers Defaulted on Their Debts in January

Source: J.P. Morgan