Behold, the high-yield exodus

Posted by Izabella Kaminska on Jun 24 14:05.

Uh oh. This is worrying.

From Standard Chartered’s latest credit research report on Friday:

Investors continue to desert HY bond funds in droves as outflows accelerate.

Meanwhile, the WSJ reports:

Investors withdrew a record $3.43 billion from mutual funds that focus on high-yield bonds in the week ended Wednesday, according to Lipper, a unit of Thomson Reuters Corp. The exodus, following net withdrawals of $1.62 billion a week earlier, is a measure of how eager investor are to avoid risky assets amid a welter of economic bad news. “A combination of factors across the globe, ranging from Greece to slower economic growth in the U.S., are causing investors to flee risky assets,” said Brad Rogoff, head of U.S. credit strategy at Barclays Capital in New York. This week’s outflow is the largest since 1992.

Needless to say, it’s worth keeping an eye on the mammoth asset re-allocation, since it could become relatively significant.

As FT Alphaville has reported, investors have over the last couple of years piled into high-yield bond funds and securities in a bid to capture yield. Any yield. The high-yield sector obviously being one of very few offering an attractive cashflow return in the current climate. At the time, it seemed like a sensible idea. The Bernanke put would, after all, guarantee few losses, right?

Though some did fear investors had taken leave of their senses when it came to risk.

So what to make of this huge reversal? And what are the implications? Could this turn out to be a bigger destabilisation trigger than a sovereign debt crisis?

For now, the message from market analysts is, as we have pointed out before, conflicted. Some argue there are major downside risks on the horizon, whilst others are still recommending the sector as a growth area.

But with a wealth of exchange traded products tracking the high-yield sectorhaving already run into liquidity issues, and implied volatility for the sector rising beyond that of the equity market, we would say there is reason to be fearful.

It’s worth remembering that there’s a synthetic factor to be considered, too. The limited, illiquid and hard-to-source nature of the high-yield bond market made it a natural for the development of synthetic alternatives. But as FT Alphaville has noted before, those synthetic products require someone to take the other (short) side of investors’ long bets. Or at least the banks brokering the deals to step-in as middlemen.

So who knows how those outflows will be spread in terms of daisy-chain effects through the market.

One thing’s for sure. There’s been an array of new (and much more exotic)  high-yield related investment products being launched this month.

One of the most exotic being the ProShares Inverse High-Yield Bond ETF, the first ever inverse high-yield fund, which uses derivatives to short high-yield bonds. One look at the fund’s prospectus reveals it’s stuffed with all sorts of short HY swaps — i.e. it’s very synthetic.

But, if anyone feels like being the synthetic short to all those synthetic longs, we presume that’s the way to do it. Not that this is a recommendation. We’d be mindful of the four pages worth of derivative risk disclosed within the prospectus.

Related links:
Record retreat from junk bond funds
– FT
Demand for high-yield assets boosts risky second lien loans
– FT
Investors really ♥ junk. We mean really. – FT Alphaville
Equity shorts in disguise
– FT Alphaville

This entry was posted by Izabella Kaminska on Friday, June 24th, 2011 at 14:05 and is filed under Capital markets. Tagged with , , , .

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