Here's Why The Cracks In The Junk Bond Market Could Be Ominous For Stocks

The market for junk bonds – or high yield debt – has been on a tear as investors have poured money into the asset class.

But that market has recently started to show some cracks.

Bloomberg's Lisa Abramowicz reported earlier in the week:

Investors yanked a record volume of cash from BlackRock Inc. (BLK)’s exchange-traded fund that buys junk bonds as the notes lose value for the first month since May.

The $16.3 billion fund reported an outflow of 2.4 million shares yesterday, equal to about $218.9 million, according to data compiled by Bloomberg. That’s the biggest daily withdrawal in the five-year history of the iShares iBoxx High Yield Corporate Bond Fund, the largest of its kind.

The obvious question, then, is where the market goes from here – do the redemptions continue, or does activity level out? Although the future is uncertain, especially amidst a selloff, the consensus prediction is that it will not last long given the broader interest rate environment and investor demand for yield.

However, if the market comes under sustained pressure and interest rates on high yield bonds rise, it could present a headwind facing the stock market, according to Martin Fridson, the man known on Wall Street as the "dean of high yield debt."

Fridson told Business Insider that if high yield were to continue selling off, the biggest implication for other asset markets would be the removal of the cushion on the downside that the prospect of private equity buying gives big industrial stocks – paving the way for more selling in those sectors.

Here is Fridson's explanation:

Beyond high yield investments themselves, one of the most important [implications of a sell-off] would be the private equity market. We were getting to a point where you get below the average spread, and actually, we are right about at the median historical spread, slightly lower than the mean.

I did an analysis about a year ago and it showed that a lot of the issuance in the high yield market is related to private equity when the spread is below the median, because it basically means it's cheap financing for private equity firms.

There are two reasons why private equity might be active.

One is that stocks are cheap, so they say they can buy a public company at less than its replacement cost, and that's attractive.

That turned out not to be much of a factor.

What did make a difference was the financing costs.

So, when high yield financing was cheap, you saw a surge in leveraged buyout activity. We are right now just at about the midpoint where it's sort of neutral, and neither favorable nor unfavorable to private equity.

In other words, Fridson found that private equity bought companies because the cost of borrowing money was cheap, not because the costs of the buyout targets themselves were cheap.

Fridson continued:

If the market weakens further, then it will be less attractive for private equity sponsors to do LBOs. The significance of that is that it removes a positive factor on the stock side. It may be nothing more than a floor, and this of course wouldn't apply so much to some of the high tech stocks, but the companies that are more basic industry companies that tend to be good for leveraged buyouts if the price is right.

You could say, "Well, the prices of those stocks won't fall below a certain level, because if they do, the private equity firms will come in and buy them, and you'll get a 15 percent rise or something like that when the LBO bid comes in for a particular company."

So, people look at the stocks and say, "All right, we don't know exactly which ones will get bought out, but we have some idea." We're not going to assume that they ought to be 15 percent higher because they will be, but all those stocks are somewhat buoyed by that potential LBO bid.

I think that's the most direct effect you see from high yield on another market.

Basically, if the junk bond market continues to deteriorate and those interest rates start to rise, the implied safety net of a private equity buyout disappears.

On the other hand, BofA credit strategists Hans Mikkelson and  Yuriy Shchuchinov write that current market conditions have become "unusually conductive for leveraging transactions for this stage in the typical cycle," and that as a result, " credit investors should be concerned about more extreme releveraging in the form of leveraged buyouts." Read more here >



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