Trouble in High Yield Bonds Begins to Spread

It has become clear now that the troubles in the oil patch and the junk bond market are beginning to spread beyond their source – just as we have always argued would eventually happen. Readers are probably aware that today was an abysmal day for “risk assets”. A variety of triggers can be discerned for this: the Chinese yuan fell to a new low for the move; the Fed’s planned rate hike is just days away; the selling in junk bonds has begun to become “disorderly”.

 

288205Photo credit: ORF

 

Recently we said that JNK looked like it may be close to a short term low (we essentially thought it might bounce for a few days or weeks before resuming its downtrend). We were obviously wrong. Instead it was close to what is beginning to look like some sort of mini crash wave:

 

1-_JNK-weeklyJNK (unadjusted price chart), weekly: the selling is accelerating amid a panicky surge in trading volume – click to enlarge.

 

To be sure, such a big move lower on vastly expanding volume after what has already been an extended decline often does manage to establish a short to medium term low. There are however exceptions to this “rule” – namely when something important breaks in the system and a sudden general rush toward liquidity begins.

As we have often stressed, we see the corporate bond market, and especially its junk component, as the major Achilles heel of the echo bubble. One of its characteristics is that there are many instruments, such as ETFs and assorted bond funds, the prices of which are keying off these bonds and which are at least superficially far more liquid than their underlying assets. This has created the potential for a huge dislocation.

We would also like to remind readers that it is not relevant that the main source of the problems in the high yield market is “just” the oil patch. In 2006-2007 it was “just” the sub-prime sector of the mortgage market. In 2000 it was “just” the technology sector. Malinvestment during a boom is always concentrated in certain sectors (in the recent echo boom the situation has been more diffuse than it was during the real estate bubble, but the oil patch is certainly one of the most important focal points of malinvestment and unsound credit in the current bubble era).

 

2-CCC and Merrill Master IIYields on the Merrill Lynch CCC and below Index and the US HY Master Index II – the former’s yield has already busted through the 2011 crisis peak, the latter’s is still slightly below – click to enlarge.

 

These sectors incidentally usually also tend to be responsible for much of the so-called “economic growth” reported in the form of aggregate statistics. Just consider corporate capex in the US in the current cycle. How much of its growth was not somehow (directly or indirectly) related to oil? So the seemingly small and unimportant sector is actually very important for the economy at the margin – it is so to speak its main “growth component”.

 

From Daily Liquidity to “Sorry Guys, You’ll Get Some of Your Money Back Someday”

Financial crises are actually quite often triggered by problems that emerge in a small and supposedly unimportant sector in which a comparatively large amount of unsound credit has piled up. Many people fail to consider how interconnected everything is in credit-land. Trouble in one sector often tends to spread way beyond its source.

There is a widespread tendency to underestimate these dangers, and one reason for this is the role played by the time element. Once the boom in the most exposed sector ends, it at first always looks as if the consequences were manageable, because it takes a long time for really serious effects to become obvious.

 

3-WTIC and HYGWTIC and HYG (with a hat tip to Steve Saville, who recently showed this overlay in the Speculative Investor) – a very close correlation that shows how important the energy sector has become for the junk bond universe – click to enlarge.

 

People who have to do with the financial markets or the economy every day can easily lose perspective on this point. For instance, more than a year has passed since some observers have first pointed out that the decline in the oil price might cause serious trouble. This message has been often repeated, but nothing really serious has happened so far – after all, the stock market is not too far off an all time high!

In addition, there are winners, namely the many people and companies that obviously benefit from lower oil prices. We suspect however that the winners in a sense have their own time line, one that is to some extent independent of that of the losers. Before the positive effects have a chance to assert themselves sufficiently to matter, the negative effects are likely to play out.

It is moreover undeniable that we are continually receiving warning signs, and yet another one has just been delivered. As Bloomberg reports, the gates just went up at a junk bond fund that hitherto offered daily liquidity, but has run into the problem that the assets it is holding are illiquid and cannot be sold at anything but the most distressed prices:

 

Third Avenue Management just couldn’t take the pain anymore. Instead of continuing to sell distressed-debt holdings at incredibly low prices, the asset manager decided to make a drastic move that will inevitably kill some of its future business. It chose to prevent investors from leaving its Third Avenue Focused Credit Fund, a $788 million mutual fund that it has decided to liquidate.

That means that these investors who want their money back are becoming “beneficiaries of the liquidating trust” without a sense of when they’ll actually get anything back, according to a notice to its shareholders dated Wednesday. “Third Avenue is extremely disappointed that we must take this action,” it said.

That’s probably an understatement. The Third Avenue fund was aiming to provide huge returns to investors by buying incredibly risky debt when it started in 2009. But when this debt turned out to have actual risks, the fund couldn’t sufficiently exit its positions to meet investor withdrawals.

[…]

A substantial portion of the fund, which had $3.5 billion in assets not long ago, consists of the lowest-rated junk bonds, which have on average plunged almost 13 percent in 2015, their biggest negative return since 2008.

[…]

Third Avenue may have been caught in a self-fulfilling spiral. As investors demanded their money back because of falling prices, the firm was forced to liquidate its holdings, pushing the prices lower on the lowest-rated notes and spurring even more redemption requests.

 

(emphasis added)

One sure sign that this is a symptom of a very serious underlying problem – the very one numerous people have warned about for many moons – is that regulators are waving it off as a non-problem and have tried their best to “debunk” it. Investors in 3rd Avenue will surely be happy to learn that their current problem is going to remain “well contained”:

 

“This is a prime example of one type of bond-market liquidity problem that many have been talking about. Some U.S. regulators have tried to debunk the idea that a crisis is brewing in credit markets as a result of a lack of liquidity. Those policy makers may very well be right in that a fund’s liquidation won’t lead to a systemic meltdown and will simply be another casualty of a difficult year for investors.

But the fact that Third Avenue took the significant, relatively uncommon move of locking in its remaining investors shows the level of desperation in the lowest-rated credit right now. More casualties can be expected, and they will continue to weigh down prices of highly speculative assets. That will have a broader effect, especially on skittish investors who want to exit stage left.”

 

(emphasis added)

Our bet is that our vaunted regulators will be just as wrong about this as they were about sub-prime mortgages.

 

Conclusion

Lately the problems in the commodities and junk bond universe have begun to spill over rather noticeably into other markets. We believe that the recent plunge in the South African Rand – triggered by president Jacob Zuma firing his minister of finance and replacing him with a relatively unknown lawmaker – shows that the markets are really on edge by now. In “normal” times this type of news may have triggered a small one day wobble in the currency. Nowadays, it causes this:

 

4-ZARThe Rand implodes – click to enlarge.

 

The fact that the stock market has also been affected recently strikes us as particularly important, because it is happening during the seasonally strong period. If you look at the years 2000 and 2007, you will notice the same phenomenon: the stock market started weakening precisely during the time when it is normally expected to be at its strongest. Admittedly the current decline is still young and may yet be reversed, so the signal is not yet definitive.

However, considering the many other warning signs (such as the market’s horrid internals, the still extant Dow Theory sell signal, the growing divergence between junk bonds and stocks, the enormous complacency revealed by long term positioning and sentiment indicators and the recent ominous decline in margin debt from its peak), one should definitely pay close attention. We would argue that if this recent unseasonal weakness persists, it could well be the final nail in the coffin.

 

5-SPXSPX daily – Santa Claus is not in evidence this year – click to enlarge.

 

Charts by: StockCharts, St. Louis Federal Reserve Research

 

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

7 Responses to “Dislocation Watch: Getting Run Over on Third Avenue”

  • JohnnyZ:

    Oh, that is true (most of the time), but it always helps to have someone who can tip the scales in your favor by leaning your way (and seldom “against the wind”), i.e. the Central Bank. At the end CBs were created to bail out overextended FRL institutions (and pretend to “manage the economy” for the common good). CBs care only for nominal GDP (not real), so that debts can be serviced and there are no runs on fundamentally bankrupt banking institutions, which FRL lenders (which is institutionalized fraud) constantly are. So in the process they mismanage the value creation chains of the economy.

    And then you have these periods like post GFC (2008), where credit saturation is so high (and bank solvency so low) that in order to keep the pyramid scheme of FRL going, the Fed had to step up and create most of the money for the market by diktat.

    You are right – move on, nothing to see here…

  • rossmorguy:

    HTF: Huh? Do I detect irony?

    • rodney:

      Not a chance … If you have ever read what he writes here all the time (apparently he loves Draghi because he makes a hard currency out of the Euro, HA!) you would know he means it. Best policy: Ignore. No arguing with fools, your argument won’t change their mind.

  • No6:

    Looking at these charts anyone would think that Tapering was tightening!!

    Good job we have the Fed to sort things out.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • The Golden Age Has Just Begun
      Some Things Actually Go Up Before and During the Fall... In recent issues of Seasonal Insights I have discussed two asset classes that tend to suffer  performance problems in most years until the autumn, namely stocks and bitcoin. I thought you might for a change want to hear of an asset that will be in a seasonal uptrend over coming months.   Many things, including bitcoin, stocks and leaves tend to fall in the aptly named fall... but some things actually start to...
  • A Look at the Gold and Silver Price Drop of 3 July, 2017
      Mystery Nosedive The price of gold dropped from $1,241 as of Friday’s close to $1,219 on the close Monday, or -1.8%. The price of silver fell from $16.58 to $16.11, or -2.9%. It is being called a gold and silver “smash” (implication being that one party or a conspiracy is doing the smashing).   The flight of the gold rocket, different phases [PT]   Our goal is to help you develop a clear understanding. The move was no mystery. Monetary Metals makes an intensive...
  • Adventures in Quantitative Tightening
      Flowing Toward the Great Depression All remaining doubts concerning the place the U.S. economy and its tangled web of international credits and debts is headed were clarified this week. On Monday, Mark Yusko, CIO of Morgan Creek Capital Management, told CNBC that:   “…we’re flowing toward the path of 1928-29 when Hoover was president. Now Trump is president. Both were presidents with no experience who come in with a Congress that is all Republican, lots of big promises,...
  • Tales from the FOMC Underground
      A Great Big Dud Many of today’s economic troubles are due to a fantastic guess.  That the wealth effect of inflated asset prices would stimulate demand in the economy. The premise, as we understand it, was that as stock portfolios bubbled up investors would feel better about their lot in life.  Some of them would feel so doggone good they’d go out and buy 72-inch flat screen televisions and brand-new electric cars with computerized dashboards on credit.   The Wilshire...
  • How Dumb Is the Fed?
      Bent and Distorted POITOU, FRANCE – This morning, we are wondering: How dumb is the Fed? The question was prompted by this comment by former Fed insider Chris Whalen at The Institutional Risk Analyst blog.   They're not the best map readers, that much is known for certain. [PT]   [O]ur message to the folks in Jackson Hole this week [at the annual central banker meeting there] is that the end of the Fed’s reckless experiment in social engineering via QE and...
  • The Money Velocity Myth
      Popular Imagery of Money on the Move For most financial commentators an important factor that either reinforces or weakens the effect of changes in the money supply on economic activity and prices is the “velocity of money”.   An image from an article on the intertubes that “explains” the velocity of money (one of the articles we came across started out as follows: “The economy runs smoothly only when there is enough money in circulation. How much is enough?” ...
  • Which Is Worse? America or France?
      French Fraud POITOU, FRANCE – “Which is worse? America or France?” The question must be put in context. We were invited to dinner with local farmers last night. Jean-Yves and Arlette live in a modest house in the nearby town – an efficient and cozy place built about 25 years ago. They’ve added a solarium to the back, where we had dinner.   FAF – French-American Friendship. These days it's a “which is worse” competition... [PT]   Arlette operates a...
  • The Student Loan Bubble and Economic Collapse
      The Looming Last Gasp of Indoctrination? The inevitable collapse of the student loan “market” and with it the take-down of many higher educational institutions will be one of the happiest and much needed events to look forward to in the coming months/years.  Whether the student loan bubble bursts on its own or implodes due to a general economic collapse, does not matter as long as higher education is dealt a death blow and can no longer be a conduit of socialist and egalitarian...
  • Gold and Silver Capitulation – Precious Metals Supply & Demand Report
      Last Week in Precious Metals: Peak Hype, Stocks vs. Flows and Capitulation The big news this week was the flash crash in silver late on 6 July.  We will shortly publish a separate forensic analysis of this, as there is a lot to see and say.   Silver - 1,000 troy ounce good delivery bars, approved by the COMEX. Whatever you do, do not let one of these things land your feet. For readers used to the metric system: these bars weigh approximately between 28 to 33 kilograms...
  • No “Trump Bump” for the Economy
      Crackpot Schemes POITOU, FRANCE – “Nothing really changes.” Sitting next to us at breakfast, a companion was reading an article written by the No. 2 man in France, Édouard Philippe, in Le Monde. The headline promised to tell us how the country was going to “deblock” itself.  But upon inspection, the proposals were the same old claptrap about favoring “green” energy... changing the tax code to reward one group and punish another...  and spending more money on various...
  • Putting the Latest Silver Crash Under a Lens
      An Unenthusiastic Market On Thursday, July 6, in the late afternoon (as reckoned in Arizona), the price of silver crashed. The move was very brief, but very intense. The price hit a low under $14.40 before recovering to around $15.80 which is about 20 cents lower than where it started.   1 kilogram cast silver bars from an Austrian refinery. These are available in 250 g, 500 g and 1 kg sizes and look really neat. We use the 250 g ones as paperweights, so this is an...
  • What Really Happened When Gold Crashed, Monday June 26?
      The Earth is Still Round Let’s establish three facts up front. One, the volume of contracts traded was not “millions” (as at least one conspiracy theorist is claiming). During the 1-minute window when the price of gold dropped from $1,254.10 to a low of $1,236.50 and recovered to $1,247, 18,031 August gold contracts traded. There was negligible volume in the October and December contracts. Two, the Earth is round. This did not occur while “everyone” was sleeping (as at least...

Support Acting Man

j9TJzzN

Austrian Theory and Investment

Own physical gold and silver outside a bank

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com

savant