Interest Rates markets are worth a word since the decisions undertaken by the Central Bankers directly affect: Banks=> Public and Corporate debt Markets =>Capital Markets and FX=>Hard Assets; (Commodities, Real Estate) => Retail and consumer Markets. In this cycle, High Yield index is believed to be a leading indicator.
Corporate Finance : Yields on corporate credit are important.
“Corporate credit yields” is a general term for the rate at which companies can issue debt (that is, borrow money). Many energy companies outspend internally generated cash flow, requiring them to seek funds from outside sources such as the debt capital markets.
Higher corporate credit yields mean more expensive borrowing rates , so higher yields are generally negative for companies, especially capital-intensive refiners and energy producers.
These needs might also include working capital refinancing coming due.
Companies that will need to raise money will be forced to do it at higher rates as yields move upward. (it’s a just normal part of the Business Cycle coming after a recession and the most unprecedented money printing operation).
The L Issue:
Once the Federal Reserve and other Central banks rise interest rates, they will change completely the Market Structure (Yield curve).
This change in the market structure, is a tipping point.
High Yield Debt markets are thin and notoriously illiquid markets maintained by a few dealers. Even a small yield curve (down or up ) shift will drain liquidity in the Bid-Ask quotes… (This is true for commercial paper, options and all thin markets…)
That’s why refinancing becomes tricky when the market structure changes, as the borrower may end up paying 300 bps because of the yield curve change plus 100 bps more because of a widening in the bid-ask spread quote.
The Bank of America Merrill Lynch High Yield Index describes the market premium over Treasury Curve with a model integrating two types of volatility; variable interest rates and variable prepayment rates.
Without the FED assets purchases and in a slow growth economy, High Yields reaching the 6-7% mean yield perceived risk-ratio is in the radar.
. The Bank of America Merrill Lynch High Yield Index describes the market premium over Treasury Curve with a model integrating two types of volatility; variable interest rates and variable prepayment rates.<SVRX:IND> <GO>
Volatility is firming, these markets are (at least) now predicting rates to increase earlier than they were expecting months ago.
I suggest to use 2 yrs Interest rate Swap to become a “payer”. (Payer refers to the party that wants to pay a fixed interest rate and receive a floating rate of interest.)
This is a hedge against rising interest rates with an embedded hedge feature against the future bid-ask liquidity risk.
Hedging with Interest rates options series is particularly attractive during low period of volatility. For an option buyer, the risk limited to the premium you pay.
Right to exercise
Because you can exercise the option, the liquidity risk is zero.
The trick is that if your option is in the money and you want to cash out, with an american style option you can always choose to exercise at the strike price during the life of the contract.
Example: On theBank of America Merrill Lynch High Yield Index Chart back in 2008: the yield reached 22% ? (dealers are quoting you 11% yield).
The option cost is 250,000, current interest rate are 7%. The strike rate is 11%. The hedge is for a 80 m$ future borrowing for 5 months.
The option is in-the-money
i) If you owned a long option interest rate option on the index, you could notify that you will exercise it the strike + immediately short 10Y futures to fully lock the gain.
80 m$ *(22%-11%)-cost of the option= +8,55 m$
ii) You wait a couple of day after, you are still hedged but the value of the position is much lower.
80 m$ *(11-11%)-cost of the option= -250,000 $
For the same risk management / hedging policy: two different outcomes.
Hedging is apparent to trading; you sell risks to the market. Because the market value of risk also changes, your outcomes depend on how you implement hedging.
Because of a previous bad execution, many people will become increasingly skeptical about hedging and will not delve further into the subject…
S/D Interest Rates, High Yield Market and the Business Cycle
B/S asset-liabilities funding specialists working for Banks are the primary market makers/ traders of these markets.
Borrowers are just the price-takers. Even if they shop rates among 15 different banks, they remain price takers.
Banks are the market makers.
Mr. Dimon also said that the recent rise in the yield of 10-year U.S. Treasury bonds is a welcome step towards normalization of interest rates, but pointed out that rates remain low. A more normal yield is 5%, he said. On Tuesday, Treasurys were trading at a 2.21% yield. – J.P. Morgan’s Dimon on Yields. 11 Jun 2013 WSJ
In recent years, rates have been correlated mainly with macro factors. The Federal Reserve Billions monthly buying program ( artificially increasing the demand and causing interest rates to fall.)
When these actions are removed, the rates go up like a slingshot.
The Bank of America Merrill Lynch High Yield Index <H0A0:IND> is rising and has reached yearly high in July.
Money flows is also suggesting that funds want better Yield Bond.
10 YR T-NOTE
The 10-year note 10_YEAR -0.73% yield, which moves inversely to price, rose 22 basis points on the day to 2.725%, marking its highest closing yield in 23 months.
U.S Economy is Growing
The U.S. economy created 195,000 jobs in June, beating expectations of economists.
The Rise in the HY bonds is a red flag for highly-leveraged businesses but generally a good outcome for the economy as it sends a signal that central banks interventions are no long required (The Federal Reserve is considering that the general outlook for the economy is positive).
Yields on junk-rated debt have risen to their highest levels this year after Federal Reserve Chairman Ben. S. Bernanke said June 19 the central bank may begin reducing its $85 billion in monthly bond purchases this year, marking a slowdown in stimulus measures that pushed investors into riskier assets and sent yields to unprecedented lows. -Bloomberg Jul 1, 2013
Junk-bond yields have fallen so low that below-investment-grade bonds were no longer a compelling investment.
Scalpers: Don’t need bond-yield inverse relationship theories to live but Corporate Borrowers, yes.
The consensus is that The FED is ready to use its magic wand by many small increments. It’s a tipping point for Bond Traders who are ready to move the 2YR, 5 YR, and 10 YR U.S T-Note, Corporate and high yield debt.While waiting for the next FOMC minutes, the big players are likely to squeeze out the small players before dropping bonds.
Bond prices have to become cheaper (so yield must be higher) to compensate investors for the futures interest rates hikes (as future bond issues will command a higher yield %).
The yield curve tends to flatten when yields rise and to steepen when yields fall as illustrated on this figure.
Corporate Borrowers: For undhedged/highly-leveraged borrowers that will have to go in the market, changes in the market rates structure are tricky. Ultimately, higher yields will help building a market demand for Risk and a healthy debt capital market will be built upon this series of rates hikes. . ( the invisible hand will replace the artificial support of the central bank intervention)…
-The Trade Shipping and Finance Wizard