Thursday, December 15, 2011

Riding the volatility in the junk bond markets

The world of junk bonds (HY) has been particularly turbulent this year. The market not only experienced tremendous volatility, but also saw significant divergence in the performance of  different quality bonds. With risks of global recession constantly circling the markets, investors started gravitating toward higher rated, lower leverage names. In spite of the recent stabilization in the HY market, the "CCC" component continues to lag the higher rated paper.

JPMorgan Domestic HY Index for BB, B, and CCC bonds
The credit market is pricing in some probability of a substantial slowdown in the US that will rapidly increase the debt to earnings ratio for CCC-rated firms, making them vulnerable to default.

But there is another factor driving HY volatility this year. With significant interest in corporate bonds from retail investors, mutual funds and ETFs have been a big driver of supply/demand technical. And investors have been trading that market rapidly, trying to time the rapid “risk on”/”risk off” fluctuations. That translated into erratic inflows and outflows for HY mutual funds on an unprecedented scale as the chart below shows.

This fund flow volatility in the HY markets will continue to whipsaw market participants, exacting pain on those who don’t have the staying power to ride out the Europe-driven market storm.
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