E November Rain

Buying dips has been a popular strategy since the Financial Crisis. Thus, when credit spreads blew out during the August-September 2015 market rout, many pundits and portfolio strategists suggested buying high yield debt on the dip as well. Bond Squad was opposed to this idea as weakness in the corporate credit markets was much more fundamental than it was technical or even emotional. Instead, I suggested selling risk on spikes. This was not a popular concept among Bond Squad readers as it contradicted what investors and advisors were being told by their respective firms. However, market data indicate that de-risking into spikes turned out to be a prudent tactic.

Credit spread of B-rated U.S. Corp. Bonds vs. UST Benchmarks (Source: BAML)

As you can see, following a recovery (spread narrowing) in October, high yield credit spreads trended to recent wide levels Thus, if one took advantage of, what appears to be a retail investor/wealth management-driven recovery (spread narrowing), one did oneself a favor. This is not 20/20 hindsight on my part. Since June 2014, I have warned of outright overheated conditions in the high yield credit markets. More recently, in the 10/29/15 edition of “In the Trenches” I wrote:

Slowly tightening financial conditions could help keep the economy chugging along while keeping inflation in check (not that the Fed has to worry much about inflation as currency devaluation around the world is tightening for them). However, for high risk asset (CCC-rated bonds and loans), investors could be cooked like the proverbial frog in a pot with slowly deteriorating credit conditions. In my opinion, it might be better (where suitable) to move up from the riskiest asset classes into higher-quality investments. Since the expected fed policy and global central bank policy both augur for low inflation, it is probably better to pick up yield by taking on some duration risk rather than by taking on increased credit risk. However, investor suitability should be the ultimate determining factor.

I remain very concerned with the bottom of the junk debt markets. Following a mild recovery earlier in the month, yields of CCC-rated junk debt have begun to trend higher again, even as BB-rated yields have declined. This appears to indicate a renewed rotation out of the riskiest areas of the high yield debt market. Although much of the weakness is among energy and commodities companies, continued weakness could bleed over to other sectors within the junk debt universe.