As Everyone Now Sees “Bubbles In Credit”, Debt Investors Quietly Exit Stage Left

With first the ECB, and now the BOE, having encroached into the corporate credit markets (last week we showed that the ECB was now directly funding European purchases of US companies), one would expect a full-blown frontrunning surge as investors bid up bonds ahead of purchases by two central banks, who will shortly encounter a substantial shortage of willing bond sellers. Which is what happened just after the recent announcements.

However, even as they buy, credit investors know the good times won’t last. In fact, in a paradoxical twist, as BofA reports in its August’s survey of IG and HY market participants, as the ECB and BOE intervene and now directly manipulate the credit market, investors have been inclined to pare down risk. 

As BofA reports, its high-yield survey shows that investors have reduced risk significantly over the past two months and now running an UW positioning again, compared to OW in June. Cash positions have increased from 3.1% in June, to 3.3%. Current cash balances are now off the lows we saw in June. Outflows from HY funds and the increase in cash balances have contributed to the risk reduction in the asset class.

Why? Because nearly half of investors are sober enough to appreciate what it taking place: a “bubble in credit.” Here is BofA’s summary of what credit respondents said when asked what they are most concerned for the next 12 months:

• “Bubbles in credit” jumps to the top of HY investors’ worry list (47%, from 20% in June) also keeping the top spot in the IG investor survey.
• Quantitative Failure is now on the second spot and third spot for the IG and HY survey respectively.
• Note that there is virtually no investor across both our IG and HY surveys who are worried about “Brexit” anymore (although “populism” is a new worry). In HY, “EM/China slowdown” has fallen from the top worry in June, to now being at the bottom of the list.

And in a related question, this is what respondents said the rapid growth in negative yielding assets would lead to.

• 60% of high yield investors see the rapid growth of negative yielding assets leading to a “misallocation of capital”. 43% of IG investors think the same.
• Negative yielding assets are another way to say “Quantitative Failure” according to 26% of IG investors.
• Only 17% of IG and 20% of HY investors see the rapid growth of negative yielding assets as a bullish signal.

Butp erhaps the most important How do investors feel “most comfortable participating in the reach for yield trade?” The answer:

• The best vehicle to reach for yield is by “buying subordination”, according to slightly more than a third of both high-grade and high-yield investors.
• An equal number of IG investors see “buying $ paper” and “extending duration” as the primary way to add yield.
• High yield investors prefer to extend duration as opposed to buying $-paper.
• Moving into lower quality credit and adding EM-exposure are lower on the priority list for both IG and HY investors.
• Interestingly, 6% of IG credit investors would consider buying structured credit

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In other words, investors are perfectly aware that bonds are a bubble, that central bank policy is leading to misallocation of capital and so, what do they do?  Why they buy subordination, or debt that is even lower in the capital structure and has less protection but offer fractionally more yield.

Because as long as the music plays, one has to dance.