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”.
Photo 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:
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).
Yields 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.
WTIC 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.
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.”
Our bet is that our vaunted regulators will be just as wrong about this as they were about sub-prime mortgages.
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:
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.
Charts by: StockCharts, St. Louis Federal Reserve Research
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7 Responses to “Dislocation Watch: Getting Run Over on Third Avenue”
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