The federal shutdown's impact on high yield bonds

Shutdown dented high yield bond market, but rally may resume soon

The government shutdown

Last week’s volume was pretty much null given the government shutdown, but there may be hope. The recent drop in the high yield market (HYG) is driven by two factors that in turn drive each other:

  • Risk-off mentality
  • Reduced issuance

HYG vs SPY 2013-10-08Enlarge Graph

Risk-off mentality

The risk-on mentality is quite obvious. Given the uncertainty of the length of the shutdown and the degree of damage it can cause to the economy, investors have fled to safe assets.

While bonds are considered safe, they’re not the same as Treasuries since high yield bonds carry significant credit risk given that they’re backed by below–investment-grade issuers. When risk is on, spreads widen, and widening spreads mean higher bond yields and hence lower bond prices (JNK).

While some investors may ask why people would flee to bonds when the US is at the brink of default, the answer is simple. The market and politicians are assuming the US won’t default. The shutdown is related to the budget, and only 7% of the budget goes to paying debt. As of now, the market is assuming that a solution will be found within the next week or so before the US gets close to the debt maturities later in the month.

Even then, the maturing debt can roll over, keeping total debt constant, and the government would still have resources to pay interest. On October 17, the government will roll over $120 billion of debt, but the problem is that by October 22, the Congressional Budget Office expects to start missing payments, so the rollover only buys an extra week or so.

If the government doesn’t come to an agreement by the end of this week, the market may start to price in some default risk based on the October 22 maturities, and that’s when, probably, only gold will be safe. Gold hasn’t rallied in the past week since the market assumes Congress is crying wolf again, but if the debt ceiling isn’t raised, the wolf will come to town and gold will spike.

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