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What does the credit market tell us?

07.03.2016

Norwegian high yield bond funds are down ten percent so far this year, and credit spreads in the bond market are on recession levels.

Risk premiums on US corporate bonds have risen sharply during the winter. Historically, the economy has been in recession ninety percent of the time when credit spreads were at current levels.

Is the bond market attempting to warn us that recession is right around the corner?

We doubt it, and think that it is instead a signal that corporate bonds are undervalued and that they represent a buying opportunity. Let's look at the driving forces behind this winter's spread widening.

Commodity collapse

It all started with the collapse of the commodity market. The past decade's investment boom in oil and mining industries were largely debt financed. Historically low commodity prices will bring a bankruptcy wave going forward. However, at the current level the credit market has already factored in huge losses.

Furthermore, it is important to remember that the aforementioned sectors weigh much heavier in the credit market than the economy. The reason is that lenders have a penchant for companies with physical assets such as mines, oil fields, ships and drilling rigs.

Collateral in Internet domains, software and trademarks are not popular among creditors.

Liquidity drought

The second reason for the spread differential is capital outflow from bond funds combined with low market liquidity. Stricter regulation of the banking sector after the financial crisis has led to an unintended liquidity drought in the bond market.

Banks' ability to engage in proprietary trading, market making and provide trading credits to hedge funds has been greatly limited. This has resulted in a general decline in liquidity in all parts of the securities market, but bond markets in particular have been hit hard.

All went well as long as the money poured into the funds. Then companies used that big willingness to invest to print corporate bonds like crazy.

Redemption panic

The problem occurred only when money flow went into reverse. US high yield funds have lost 15 percent of their total assets this winter.

This has triggered a self-reinforcing negative spiral in which the funds are forced to dump bonds at lower prices to meet liquidity needs. The fall in bond prices has in turn weakened the return on the funds even further, which has caused alarm and even more redemptions.

On top of it all, one bond fund was forced to suspend the redemption of fund units completely as a result of insufficient liquidity in the underlying securities. This fueled the redemptions panic even more. 

Disengaging

Shrinking liquidity has caused the corporate bond market to overreact and disengage itself from the underlying fundamentals.

So is it a good idea to buy oil industry bonds? If you have a long time horizon, the answer is yes. At the current level, you get overcompensated for the default risk. However, looking from a purely tactical point of view - it may be beneficial to wait.

During late April and early May a strong stock-building occurs in the oil market for seasonal reasons. With already brimming inventories, the risk is that oil prices will have a new crash in this period.

If that happens, cheap energy bonds can become even cheaper.

Dovre portfolio:

  • Kongsberg Automotive
  • Storebrand
  • Marine Harvest
  • Yara
  • Nordic Semiconductor
  • Europris

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