While equity markets around the world seem to have stabilized in the last few weeks, and even commodity prices (perhaps most notably, including oil) have firmed up, there are also few encouraging signs of revival in the U.S. credit markets, particularly in the non-investment grade sector.
While equity markets around the world seem to have stabilized in the last few weeks, and even commodity prices (perhaps most notably, including oil) have firmed up, there are also few encouraging signs of revival in the U.S. credit markets, particularly in the non-investment grade sector. So as the overall economic and market mood seems to have brightened a bit, this may also translate into a gradual upturn in M&A activity and corporate deal making as the credit market regains some strength.
In the last few weeks there has been a strong resurgence in the U.S. high-yield bond market. As reported recently by the Wall Street Journal, since mid-February junk-bond prices have surged alongside those of other risky assets, such as stocks and commodities, reflecting renewed confidence in the global economy and receding risk of a U.S. recession.
This recent strength in the junk bond market comes in the wake of a six-month skid throughout which the U.S. high-yield bond market suffered a substantial loss of liquidity. So while the good news (for now) is that price action has been strong to the upside for two weeks running, there is clear indication that the U.S. high-yield market is troubled by a longer-term structural problem, which remains unresolved. According to a recent article in the Business Insider, “Liquidity is the main source of the extreme downward and upward moves in the credit market now,” in the words of one market source quoted in the article. This sentiment has been echoed in recent commentary from sources no less authoritative than Jamie Dimon at JP Morgan and Steve Schwarzman at Blackstone. Read the full article here.
There appear to be two major causes contributing to the sharp drop in credit market liquidity. Up until the last two weeks, hedge funds were noticeably less active in the market, even as the wave of downgrades and defaults presented ample buying opportunity. That’s likely because hedge funds themselves had been facing their own liquidity concerns, as poor hedge fund performance has created a substantial increase in the rate of investor redemptions, with an estimated $21.5 billion in hedge fund outflow in January 2016. As a result of heightened redemption risk, many hedge funds switched decisively to a “risk-off” mode, showing a decided aversion for high yield bonds. And as usual, the lack of market liquidity became a self-reinforcing tendency among portfolio managers.
The second factor contributing to illiquidity in the high yield market was the sharp reduction in bank exposure to the asset class, due to regulatory changes in the wake of the 2008 financial crisis. With banks on the sidelines and hedge funds shy of the risk, it had been nearly impossible for high yield bonds to catch a bid, particularly at the distressed end of the spectrum. Now that sentiment appears to be changing, and some hedge funds are rotating back into riskier assets, junk bond prices are surging, but the sharp swings in price only underscore how the longer-term problems with market liquidity remain unaddressed.
Meanwhile, the secured end of the credit market also appears to be moving in a more positive direction, as measured by narrowing losses. In February the S&P leveraged loan index fell by 0.53%, slightly better than the 0.65% loss recorded in the prior month. This marks the continuation of the longest stretch of consecutive down months on record, as the index’s losing streak has now extended to nine months. But compared to the extreme sell off in the high-yield market, the losses in the leveraged loan market have been nowhere near as severe, nor has the market shown signs of severe illiquidity.
Leveraged loan funds have faced much more modest cash outflows, with a net outflow of slightly more than $350 million recorded for the week ending March 2, which marks the 32nd consecutive weekly outflow, aggregating to fund withdrawals of more than $17.6 billion over that span. But the modicum of good news is that the rate of fund outflow in the leveraged loan market appears to be subsiding, and now there’s a strong likelihood that trend will reverse.
So on the whole, the conditions in the U.S. credit markets show signs of renewed strength, although the long-term liquidity problems seem likely to re-emerge when market sentiment turns negative again. For now though, with junk bond prices moving strongly to the upside and leveraged loan prices likewise firming, it’s not hard to imagine that corporate deal making may resume a more active pace – at least for those mid-market and larger transactions dependent on high-yield issuance.