The Overnight Report: High Yield Horrors

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By Greg Peel

The Dow closed up 103 points or 0.6% while the S&P gained 0.5% to 2021 and the Nasdaq rose 0.4%.

Economy Blues

The new Treasurer will deliver the government’s mid-year economic and fiscal outlook (MYEFO) today and unless you’ve been hiding under a rock you’d know that the budget projections of six months ago are set to be substantially reeled in due to the collapse in iron ore and energy prices. The impact of this focus on the Australian economy is to scare the market into realising it’s not just a resource sector story.

It was predictable yesterday that the 100 point fall in the ASX200 would be led down by energy (-3.3%) and materials (-2.2%) but a 2.4% fall for the banks is indicative of a market concerned about the widespread economic implications of a bigger budget deficit and the response the government may be forced to implement. All sectors finished in the red to varying degrees.

There was also no doubt an element yesterday of finally giving up on any possibility of a much talked about Santa Rally. That’s the problem with something everyone takes for granted as being a given. No rally? Then we must sell.

There was likely also an element of fear with regard recent developments on Wall Street. Falls in commodity prices are cut and dried, but the freezing of redemptions of US high-yield bond funds brings back eerie memories of the freezing of redemptions of many a straightforward equity fund back in 2008. Just how onerous is this issue?

Creeping Doubt

The problem for the US high-yield market at present is that the ebbing tide of oil-related junk bond values is dropping the value of other junk bonds that have no connection to oil and indeed are not in any sort of trouble. This is brings us to one of the fundamental problems of exchange traded funds.

ETFs have become a very popular way to trade baskets of securities as the grunt work of portfolio creation is the responsibility of the fund sponsor, allowing the investor to buy one single security that’s traded on the market just like a stock. Within the most popular high-yield bond ETFs traded on Wall Street are plenty of junior oil company bonds, and given a lot of these companies are set to go to the wall the natural response is to sell.

But one has to sell the whole ETF, when oil-related bonds may make up only, say, 12% of the portfolio, as is the case with at least one of the most popular. This suggests the possibility of a snowballing across sectors. The good news, however, is that when one redeems a bond ETF, one does not receive cash but those actual bonds that make up the ETF. There is thus an incentive for bolder traders to buy the ETFs being sold by panic sellers and pick out the good stuff that has been sold down implicitly below individual trading values. If the subsequent arbitrage profit exceeds the loss on the oil-related bonds that can’t be sold then the trader comes out a winner.

And that is why EFT managers were quick to point out last night that while there is indeed a rout going on in high-yield EFTs at present, managers re not having to break up the ETFs and sell the bonds to any great extent because there are plenty of buyers for the ETF at fire sale levels. There is thus an orderliness, and hence no reason to panic, which is very much different to the sub-prime sell-off of 2007 in which no one wanted to buy.

Markets do, however, tend to panic first and then think it through later.

Thus we saw a 300 point fall in the Dow on Friday night and early in last night’s session, the Dow was down another 127. At that point the S&P500 had crossed the psychological 2000 level. But critical to the stock sell-off was further initial selling in WTI crude, which traded under US$35/bbl.

And every time we see a big oil sell-off we see the buyers come in in the belief this time simply must be the bottom. They haven’t been right yet, but they will be right one day. WTI rallied back to close above 36, and the Dow came back to the flat line. The average was still flat within the final hour before the buyers poured in on the death.

This would tend to suggest Wall Street has concluded there will still be a Fed rate rise on Wednesday. The speed of the high-yield sell-off these past few sessions has led to some creeping doubt about whether such a development might be the one thing that would change the Fed’s mind, and lead to a decision to hold off.

What the FOMC members have to decide is whether a decision not to raise would send such a negative message that the volatility that would follow would be far more extensive that what we are currently seeing in one corner of the market.

Commodities

West Texas crude is up US81c at US$36.29/bbl having hit a low of US$34.53/bbl. Brent is steady at US$37.91.

Hallelujah! Iron ore rose US50c to US$37.50/t. Pass the bubbly.

The LME appears now to have gone quiet ahead of the Fed meeting. All base metals finished in the green but only by small amounts.

The US dollar index is steady at 97.66 but gold is down US$12.60 to US$1064.70/oz. The market is likely squaring up ahead of the Fed.

And it seemed one currency that might be safe to hide in is the Aussie. Last night saw a rally which has taken the Aussie up 0.8% since Saturday morning to US$0.7243.

Today

The SPI Overnight closed down one point.

Yesterday the ASX200 closed on its low at 4928. Closing on a low is always a worrying sign but the index did just manage to stop short of technical support at 4925. That will be a critical level for today unless we do follow Wall Street with a rebound.

As noted, Scott Morrison will deliver MYEFO today. The minutes of the December RBA meeting will be released and we’ll see house price and vehicle sale numbers.

Of interest in the US tonight will be the monthly CPI release, but no one is expecting the result to impact on the Fed decision at the eleventh hour.

Mesoblast ((MSB)) will provide a quarterly update today.
 

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