Markets were generally buoyant in June and July as participants focused on the positives and largely ignored higher risk-free rates and other phenomena that had a negative impact on asset prices. The ICE BofA US High Yield Index encountered resistance within the low option-adjusted spread (OAS) range of 400 basis points (bp), consistent with resistance seen for much of the past 12 months.
But patience might be rewarded. Why? Because certain areas of the market are more advanced than the basics justify. Momentum and fear of missing out (FOMO) appear to have driven price motion in June and July. An expensive market that’s becoming dearer is considered one of the harder conditions for a fundamentals and valuation-oriented positioning approach.
But despite an overall fully priced market, some attractive individual opportunities remain for those willing to search for them.
Six or seven months ago it looked just like the U.S. high yield market was going to be in a short-term volatility range. A rally beyond the low 400 basis point spread area gave the impression to be a challenge. Although the market has broken through the 420 basis point level several times within the last six months or so, this will indicate an overextended market moderately than a transition to a brand new reality with tighter spreads.
ICE BofA US High Yield Spread (basis points)
Source: ICE/Bloomberg
There are many signs of late-cycle dynamics. The increased capital costs of the last 18 months or so aren’t yet noticeable for a big a part of the market. Price movements in response to the unreal intelligence (AI) craze have drawn comparisons to the tech bubble of the late Nineties, and a few have argued that it could take years to achieve its peak.
The current market environment is probably going an echo of the speculative bubble of 2021, when cryptocurrencies, non-fungible tokens (NFTs), meme stocks and special purpose acquisition corporations (SPACs) were all the fashion. AMC, Bed Bath & Beyond and other stocks posted spectacular short-term gains well into 2022. It’s a foul sign when the fundamental market driver looks like a bubble and the rationale for investing in it’s the longevity of the bubble. com bubble. Ultimately, this bubble was so unrealistic that the NASDAQ fell 80% from peak to trough and the Federal Reserve cut its federal funds rate by 4.25% on a net basis.
While central banks’ hawkish signals have hurt bond markets this summer, longer-term higher regulation is benefiting floating-rate securities, including leveraged loans and interest-adjustment preferred stocks. The market has been pricing in higher long-term rates of interest than indicated by the Federal Open Market Committee (FOMC) for months, but June’s updated forecasts showed a comparatively significant move amongst voters: Seven of 17 respondents predicted a long-term rate of interest above 2.5%. In March only 4 had predicted that much, a 12 months ago only two. And these projections should be far behind the curve, even in the event that they represent a slow acknowledgment of reality.
There are cracks and structural problems in several areas of the credit markets. With many mortgages coming due in the subsequent few years, business real estate is a selected problem. Although this is just not news to the market, the impact has not yet been fully realized. In the leveraged finance space, the shortage of collateralized loan obligations (CLO) could lead on to more issuers entering the high-yield market, increasing investors’ pricing power and issuers’ cost of capital.
Now may very well be a very good time to build up excess capital to deploy tactically in the approaching months as the chances improve.
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Photo credit: ©Getty Images / Koh Sze Kiat
