For years, this website and many others (such as Goldman), had been warning that in the brave new world of activist central banks in which there is virtually no risk left as any downturn is met with aggressive central bank interventions, there is also no liquidity as central banks themselves have displaced all other actors and have flooded the market with artificial liquifity, and as a result “liquidity has become the new leverage” when it comes to specific risks plaguing various assets, and especially corporate bonds.
Yet while the warnings came and went, bond spreads – both investment grade and junk – continued to grind ever tighter as yields tumbled across the entire fixed income universe, and in some European cases, “high” yield bond yields even turned negative.
All that appears to have come to a long overdue end in recent weeks, as liquidity premiums for both IG and junk bonds have suddenly jumped higher. In a recent bond market analysis, Goldman strategists looked at the relative value performance of illiquid vs. illiquid bonds, with the results of Goldman’s estimates of the average spread pickup provided by illiquid bonds over their liquid peers in the IG and HY markets shown in the chart below.
The key takeaway from Exhibit 1 is that the illiquidity premium, i.e., the spread differential between illiquid and liquid bonds, has been drifting wider in both the IG and HY markets, reaching its highest level in two years. The underperformance of illiquid bonds is further illustrated in the next chart, which shows the cumulative excess return (rates-hedged) on a long-short strategy involving illiquid vs. liquid bonds.
As the chart clearly shows, the poor showing of illiquid bonds has been particularly pronounced in HY, with liquid bonds outperforming by 2% over the past two weeks.
As with the relative value of high vs. low price bonds, Goldman thinks the risk-reward in being long illiquid bonds remains poor despite the new highs made by the illiquidity premium, especially when considering recent market repricing events of illiquid securities such as those of Woodford, H2) Asset Management, GAM and so on.
Why is this happening? While we provided an extensive response in “$1.6 Trillion Fund Spots A New, Ticking Time Bomb In The Market“, Goldman writes that aside from the more fragile post-crisis market microstructure, weak growth sentiment, lingering policy uncertainty, and relatively expensive valuations leave ample scope for further underperformance of illiquid bonds (and let’s not forget the pernicious artificial liquidity provided by central banks and HFTs).
Of course, if the market is finally starting to correctly account for an illiquidity premium, one will expect a violent bond dispersion in both IG and HY, and that is precisely what is happening because as the chart below shows, dispersion is surging from rock-bottom levels, with Goldman warning to “brace for a new regime.”
Pointing to the above chart, Goldman warns that “bond-level dispersion in the IG and HY markets has begun to rise, having been muted in the years prior to that.” Specifically, the bank uses two measures to capture bond-level dispersion: the first measure shown in the left panel of Exhibit 3 is calculated as the normalized standard deviation (coefficient of variation) of monthly excess returns across the bond constituents of the iBoxx IG and HY indices. The second measure shown in the right panel of Exhibit 3 is a normalized inter-decile range, i.e., the difference between the 90th and 10th percentiles of monthly excess returns divided by their sum.
Both measures tell the same story: until recently, dispersion was at or near post-crisis lows, but it has started to trend upwards – a trend that will only gain more momentum if the market continues to punish illiquid bonds, going forward. Key to this view is the increased differentiation in the capital management plans of large issuers in IG as well as rising idiosyncratic risk in HY, particularly in Energy, Retail, Healthcare, and Pharma.
And finally, speaking of idiosyncratic risk, in what may be the most troubling consequence (or perhaps cause) of the market’s sudden fascination with liquidity or the lack thereof, Goldman notes that after a very long hiatus, HY defaults are once again on the rise.
Indeed, as Goldman writes, “headlines about bankruptcies and restructuring plans have recently intensified. And while the 12-month trailing issuer-weighted default rate remains at a benign level, higher frequency indicators show a notable acceleration in the pace of defaults. This is illustrated in Exhibit 4, which shows that the 12-month issuer-weighted default rate stands at 3%. The 3-month trailing HY default rate (annualized) now stands above 5% and has been steadily rising since bottoming out at 1.3% in November 2018.”
What may come as a surprise to most is that on a dollar basis, 2019 has been a banner year for default volumes with over $36 billion notional of defaulted bonds year to date, which is on track to surpass the $43 billion in 2016 as the highest year for notional default volumes in the post-crisis era (Exhibit 5).
In short a default tide has already appeared, however thus far, defaults have been highly concentrated among Energy issuers, a trend that reflects structural as opposed to cyclical challenges. The lingering weakness in oil prices coupled with weak growth sentiment may push issuers in other structurally-challenged sectors towards defaults.
Will the default tide become a tsunami? That depends on whether or not the economy slides into a full-blown recession. Here, Goldman’s US economics remains optimistic and does not expect to occur in the near term, as such the bank’s bond strategists think “defaults are unlikely to move meaningfully higher.” Of course, it won’t be the first time Goldman has been massively wrong about something, and to gauge what the market really thing, keep an eye on just how far it is willing to punish and sell off illiquid names: that will be the best tell if the market thinks that i) a recession is coming and ii) corporate bonds will be the among the first asset class to get crushed once the US economy contracts.