How The High-Yield Route Could Affect the FX Market

[ForexArticles]

In early December 2015, stories made their way into the news about high-yield funds refusing to process withdrawal requests or fund redemptions due to stress in investments. Unfortunately, this attempt to reduce stress on the funds often brings about a fear that takes some funds under and has large ripple effects to other markets. There has been a major selloff in high-yield funds or junk bonds, and many in the sector are claiming that we see a crisis on our hands.

The value of high-yield funds has been positively correlated to oil, which is nearing seven-year lows. High-yield is on the far-right tale of speculation and fund management, and they received capital to try and squeeze out a return in this low-interest rate environment, but the uncertainty of a Federal Reserve rate hike, as well as unfavorable macro conditions, continue to cause underperformance by some and failures by others.

“The meltdown in High Yield is just beginning," said famed investor Carl Icahn on his verified Twitter account Friday, December 11, 2015.

Last month, we walked through the importance of emerging markets and their effect on broader FX. Emerging markets and high yield funds are highly correlated and play off the same emotion in investors. Namely, both markets appeal to risk seeking activities to grab yields not found in other markets.

Where high-yield is finding themselves in the trouble is that a lot of the noninvestment grade debt is written on energy companies that were dependent on the price of oil to remain in business.

Many of the loans written to energy companies, of which the high-yield funds are investing in, are dependent on a price of oil above a certain level. While each bank determines that level annually, you can imagine that near seven-year lows in oil are not the level these loans were underwritten to perform.



The stronger dollar has also had a major effect on high-yield, and early 2014 when the Fed was pumping the hardest, we saw high-yield funds like Third Avenue were performing the best. Unfortunately, the closer we get to the Fed rate hike, the more stress these high-yield funds are seeing. While this may not seem applicable to foreign exchange, in the world where one market affects another, the severe stress of one market tends to impact numerous others severely.

As an indication of stress, High-Yield bonds are flashing their biggest warning sign since 2009 as average low credit grade yields have doubled since the summer of '14. Yields in this market are often higher if the underlying company has unstable income

To track high-yield yourself, you can look at the ETF that tracks the sector, HYG. HYG recently took its largest intraday drop since 2011 This large drop in HYG happened on the same day that oil dropped below $36 per barrel. Once the view that the Federal Reserve would hike rates was solidified, which happened around the same time that a market-wide acceptance of lower energy prices for longer took hold, high yields understandably turn lower decidedly for the year. High-yield funds benefit in a low-interest rate environment because they are offering looks more attractive to investors account by guilt elsewhere, but as you’ll Stern higher in the Federal Reserve that only do margins become less and their business, but they’ll have less capital coming in to invest which makes her job more difficult.

While investors of high-yield funds seem to run for the exits, we can continue to look for ripple effects in the larger economy.

The most significant impact would likely be any indication that the stress in the high-yield market would limit the amounts that the Federal Reserve would raise interest rates. Any evidence that future rate increases are less probable would immediately weaken the US dollar and likely bring strength to inversely correlated currencies.