adminNEW YORK. — “Unfortunately I believe the meltdown in High Yield is just beginning,” Carl Icahn tweeted on Friday. It was certainly a scary day for US junk bond investors, but minutes after the billionaire investor’s tweet appeared at lunchtime, the high yield market, as represented by the two large exchange traded junk bond funds, started to reverse. The funds ultimately ended down about 2 percent on the day — one of the worst days for the asset class since the credit crisis — but better than the 3 percent-plus loss they were showing at lunchtime. Does that mean the worst is over?
Two negative developments, in particular, caused the dramatic sell-off.
First, Third Avenue Management told investors in its $788 million high-yield mutual fund that it was barring redemptions, a rare and shocking event for retail investors.
Second, the oil price plumbed new depths, promising to wreak more havoc on the finances of high-yield borrowers in the US shale industry.
Friday’s high-volume selling felt like capitulation to some traders, who said it was based on a misunderstanding of the significance of the Third Avenue move, while the strength of the afternoon rebound means the bottom is now in.
That rosy judgment seems premature. US high yield bond returns will be negative this year for the first time since 2008, and there are large numbers of fair-weather investors and reluctant yield-chasers who are in the asset class and who will have to be flushed out before this sell-off is over.
Third Avenue does not seem likely to be a harbinger of more mutual fund closures to come. Its fund is very different from mainstream junk bond funds.
In fact, it operated more like a distressed debt hedge fund.
As Morningstar points out, management had invested half the fund’s assets in bonds rated below a B grade and another 40 percent in bonds that did not have a credit rating at all.
Its losses this year have been many times those of the average junk bond fund, and its unique collection of assets would have been hard to sell in a hurry even in the pre-crisis days of ample liquidity in bond markets.
So Third Avenue is not typical and ought not to be a trigger for a wider panic among retail investors.
However, it is an example of how retail investors respond to negative returns. As the fund’s losses grew over the past year, Third Avenue received more and more redemption requests; the fund was down to a quarter of its peak size when it threw in the towel.
Retail investors are going to play a much bigger role in the high-yield credit cycle this time around.
The amount of money in US high-yield mutual funds doubled from the peak of the last economic cycle in 2007, from $176 billion to $378 billion at the end of last year, according to the Investment Company Institute.
With interest rates held at rock bottom and conservative bonds yielding a pittance, high yield has attracted investors who would not normally be in the asset class.
Are they likely to hang around after seeing their portfolio statements bathed in red?
After last week’s rout, US junk bonds are showing returns of minus 4,5 percent for the year to date, according to a Barclays aggregate index.
Many high-yield investors have been comforted by the ultra-low levels of defaults on junk bonds in recent years. But those benign conditions are rapidly becoming a thing of the past. JPMorgan is forecasting the default rate among energy companies will hit 10 percent in 2016, nearly triple this year’s rate.
That pulls the overall junk bond default rate up to 3 percent next year and the bank is forecasting that it could spike even further in 2017, to 4,5 percent compared with the long-term average default rate of 3,6 percent.
Those forecasts were penned before the latest leg down in the oil price, so they probably underestimate the distress to come.
There is also a whole new area for investors to concern themselves with, as the retail sector appears to be entering a period of accelerating change.
The customer shift to online shopping has caused profit warnings all the way up to giants such as Macy’s this year; among the less robust and more highly indebted chains who fund themselves in the junk bond market, credit quality threatens to decline sharply.
All of which is to say, one does not need to predict a liquidity crisis or a run on high-yield funds to expect further declines from this asset class. No meltdown, perhaps, but a prolonged period of misery may be in store. — FT.
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