Signs of distress are mounting in the high-yield bond market.
Last week, the mutual fund company Third Avenue Management blocked redemptions in its $790mm junk-bond oriented Focused Value fund. Another company, Stone Lion Capital, did the same in its $400mm distressed debt hedge fund. And Lucidus Partners close its high-yield oriented fund and returned all money to investors.
Third Avenue’s fund, like all mutual funds, permitted daily redemptions; however, it invested in illiquid, hard-to-price, low-quality debt. As the fund’s losses mounted investors liquidated shares, forcing the fund to sell its most liquid assets first. Left with assets for which few buyers existed, management ended up erecting a “gate” to prevent a fire-sale of its remaining positions.
This turned all holders into “beneficiaries of a liquidating trust.” It is unlikely that any of the mutual fund’s holders ever contemplated the possibility that their money would be locked without any clarity on how much they would get back, or when.
The problems in the high-yield world extend to popular ETFs. Since the beginning of the year, the price of the two largest ones in that category, JNK and HYG, lost enough money to wipe out three years of dividends and price gains. Franklin Templeton’s High Income, a $5bn junk bond mutual fund, has had an even worse fate (see graph).
All corporate bonds, including high-yield, are measured by their yield “spread” over US Treasuries. This is simply the additional interest that investors demand for accepting a risky bond. The riskier the bond, the larger the spread. The spread can also widen because of a demand/supply imbalance if buyers are hard to find.
Analysts are currently debating whether current junk-bond market woes are due to these technicalities, or whether something worse is going on.
There is no doubt that liquidity in the bond market has deteriorated after the ability of investment banks to trade and warehouse bonds was curtailed by regulations created after the financial crisis of 2008. Despite this, corporate bond issuance exploded in response to high investor demand as interest rates fell. Corporate treasurers were eager to issue debt at low rates, which they used not only to finance operations but also to buy back their own stocks. The latter resulted in savings because of lower dividend distributions, improved equity metrics such as earnings per share, and propped up equity prices to which corporate management’s compensation is linked.
The explosion of debt issuance raised few alarms until recently. As we discussed in a recent newsletter (This is where the next crisis will come from, 8/21/2015), the current run-up of corporate debt is the largest and fastest in history, and comes in the wake of a crisis that was due precisely to a huge increase in private sector indebtedness (see graph).
An important challenge to the creditworthiness of some of the new debt is the decline in oil prices. Originally seen as a boon for consumers, it quickly became too-much-of-a-good-thing when investors started questioning the ability of some of the most leveraged companies in the oil business to repay their debts in the wake of collapsing revenues. If defaults rates rise, a contagion effect on those who lent to the oil industry will become an additional worry. And all is taking place in the context of a Federal Reserve intent on jacking up the cost of debt.
So are the high-yield fund troubles a sign that a market crash is near? Many bond-fund managers don’t seem to think so. They point out that since only a quarter of outstanding junk bonds are in the hands of mutual funds, there few reasons to believe that problems could spill over to other parts of the corporate bond market, let alone stocks.
That may be so. But it is interesting to note that for the last 12 years there has been a mirror relationship between high-yield bond spreads and the stock market: when spread fell, the stock market rallied and vice versa. This relationship has not held in the last year or so, as the stock market completely shrugged off the dramatic widening of bond spreads (see graph).
For this relationship to come back in line, bond spreads would have to come down substantially, creating fabulous gains for high-yield bonds. It would also come back in line if stocks crashed in a big way.
A third option, of course, is that the two asset classes have decoupled and will move independently from now on. This is possible; in a more distant past, the relationship between them was different. Entering a new period of higher rates also may play a role in breaking the familiar link.
So, it is early to say whether the junk-bond fund failures are isolated events or warning signs that big troubles are brewing. After all, past market anxieties like Greece, a US credit downgrade or the Japan tsunami did not have any lasting impact on a relentlessly climbing market. Still, it may be foolish to completely dismiss mutual fund failures as being of no importance. After all, the financial crisis was preceded by the demise of two Bear Stearns funds and the troubles of a handful of money market funds in 2008.
The Investment Company Institute reports that mutual funds currently own $300bn of high-yield debt – twice the level of 2007. This is worrisome, because mutual fund investors can and will sell their shares quickly if sentiment worsens, leaving managers to figure out how to liquidate holdings in an environment of much-reduced liquidity. This could well lead to more fund failures and a down-spiral of investor confidence.
Many times, portfolio management is about making a decision to buy insurance rather than positioning a portfolio to capture uncertain returns. Investors may need to look at this tradeoff closely and decide whether insurance, in the form of reduced exposure to risk, is a wise purchase given the current challenges that the high-yield bond market currently faces.
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