Profit taking has hit the high-yield bond sector and has led to lower prices to start the third quarter of 2014. Since peaking last month, the average yield of high-yield bonds has risen by 0.5% to 5.3% with the average yield spread to treasuries widening to 3.9%. Even after the recent increase, yields remain low and spreads remain narrow by historical standards. The pullback, though modest, is the highest since January of this year.
A number of factors may have contributed. When the average yield dropped below 5%, it presented an opportunity for some investors to take gains and reduce exposure. Also, the revelation of financial troubles at Portugal’s second largest bank, Banco Espirito Santo, added to selling pressure. Fears of systemic market risk weakened high-yield bond prices even though risks began to subside as the Portuguese government and central bank announced it would provide assistance and that private investors were ready to inject capital. In addition, global conflict generally fosters uncertainty, which can drive bond investors into higher quality assets and away from high-yield bonds. The Malaysian airline tragedy and military action in Gaza have provided a one-two combo. In a report to Congress, Federal Reserve (Fed) Chair Janet Yellen once again mentioned that a “reach for yield” was coming under scrutiny at the Fed. Her comments were, on balance, market friendly since she exhibited a great deal of caution about when the Fed would ultimately raise interest rates which is generally positive for more economically sensitive fixed income sectors such as high-yield bonds. Nonetheless, her comments weighed on the market.
That confluence of events led to lower prices and notable mutual fund outflows. High-yield bond mutual funds and exchange traded funds (ETFs) recorded their greatest weekly outflows in a year according to Lipper data. A heavy dose of selling can have an outsized impact in a less liquid sector such as high-yield bonds.
It is worth noting that Yellen also pushed back on high quality bond valuations by stating that the Fed’s forecast remained valid. But the bond market has a different opinion with futures still indicating the Fed will take longer to raise interest rates and ultimately will not raise them as high as it has indicated. Fed fund futures pricing indicates year-end 2015 and 2016 overnight rates that are 0.3% and 0.7% lower than the Fed is forecasting. In fact, the Fed has proved to be an overly optimist forecaster of economic growth.
Should economic growth disappoint consensus forecasts, what will the Fed do? Will it alter its scheduled tapering of QE or implement some alternative, such as repurchase agreements? The bond market seems to think so.
John Hess 
Falgun Jariwala 
Managing Principal Managing Director
jhess@nsinvestors.com fjariwala@nsinvestors.com
www.nsinvestors.com www.nsinvestors.com
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