An increasing number of defaults in high-yield corporate bonds — or junk bonds — is expected in coming months, as the world economy continues to struggle following a volatile 2015. What’s more difficult to predict is whether recent failures in the high-yield credit markets are the proverbial canary in a coal mine, signaling greater dangers ahead for the wider economy, or if they are simply a reflection of the greater risk that such instruments carry by definition.
Junk bonds are a potential source of fragility for the whole U.S. financial system.
” hashtag=”” url=”http://knlg.net/1VILsQT” ]“I think people who look at the financial system have to be aware that this is a potential source of fragility,”[/tweetthis] says Wharton finance professor Itay Goldstein.
Investors had a rough time all around last year. Energy prices and most other commodities plunged as China’s economy slowed substantially. The Dow Jones Industrial Average and the Standard & Poor’s 500 index both notched annual declines for the first time since the financial crisis, though they were modest. And even while merger and acquisition activity soared to new heights, debt markets became increasingly cautious and many investors started pulling out of high-yield credit instruments, roiling that segment of the market.
The iShares iBoxx $ High Yield Corporate Bond ETF, a $14.4-billion exchange traded fund that tracks the performance of the junk-bond market, posted an annual loss of 5.5%, and ended 2015 off a startling 12.4% from its February high. Likewise, the S&P U.S. Issued High Yield Corporate Bond Index lost 3.99% for the year, while BofA Merrill Lynch U.S. High Yield Index fell 5% for the year, its first annual loss since 2008.
Volatility is undoubtedly expected to be greater in riskier instruments, and some see declines in speculative grade debt as “normalization.” But the collective demise at the end of the year of several high-yield investment funds has some wondering if they are a harbinger of the next crisis.
“I think people who look at the financial system have to be aware that this is a potential source of fragility.” –Itay Goldstein
The headline grabber was the decision by Martin Whitman’s Third Avenue Management to shut down redemptions in its $788 million Focused Credit Fund and liquidate the high-yield mutual fund in early December. The fund had about $3.5 billion in assets as recently as mid-2014, but as the value of its holdings declined, investors further pressured the fund by pulling out almost $1 billion in the first 11 months of 2015 alone.
On the heels of Third Avenue, Stone Lion Capital Partners suspended redemptions in its credit hedge funds. The funds, which traded in junk bonds, equities of reorganizing companies and other speculative holdings, likewise couldn’t immediately guarantee that they could meet investors’ demands for their money.
The redemption halts naturally drew comparisons to the collapse of funds packed with subprime mortgages at Bear Stearns and BNP Paribas in 2007, which similarly stopped payouts after the value of their holdings plunged.
In both 2007 and 2015, the issue was liquidity.
That’s a red flag to Goldstein. “At the end of the day, what brought down AIG was mostly the liquidity,” he says, referring to the spectacular 2008 collapse of insurer American International Group, which bet heavily on debt instruments. When creditors demanded their money quickly, AIG could not come up with the cash, and ultimately needed two massive bailouts.
Looking at Third Avenue and Stone Lion through that lens, stopping redemptions “may not be a bad thing,” Goldstein says. “That may be the solution to it: If you identify unusual amounts of redemptions, you just say, ‘Stop,’” and then dole out redemptions on a more relaxed basis, giving the funds time to sell assets in a more orderly fashion.
Morningstar analyst Leo Acheson says Third Avenue is not a good yardstick for the health of the broader high-yield market because “it mismanaged the fund.” The fund was loaded up with highly distressed debt that made it particularly vulnerable to a liquidity crunch because it’s hard to sell. “It’s not your typical high-yield bond fund,” he says.
Yet the worrisome developments did not stop there.
On December 14, hedge fund Lucidus Capital Partners liquidated its holdings to meet investors’ demands for their money. Market watchers noted that Lucidus was able to sell its high-yield assets, and the firm said it shut down because it didn’t expect to produce the returns it once thought it would. That’s a significantly different scenario than the suspensions by Third Avenue and Stone Lion, where distribution of investor cash was delayed to avoid even bigger losses.
Next came investment firm Whitebox Advisors, which in the waning days of the year said it planned to liquidate its three mutual funds amid heavy losses and rising redemptions. The firm said the move was designed to reduce risk, that all of the funds were in cash, and that redemptions were being met. But it was another worrisome development, made more so by a memo Whitebox CEO Andrew Redleaf wrote in March 2015.
Redleaf, known for his prescient warning in late 2006 about the subprime market, said in the memo unveiled by CNBC in March that loose credit standards had distorted the markets. “I think it is a truly scary time,” the memo stated, suggesting there were some parallels with the collapse in home prices that preceded the economic meltdown of 2008.
Signs of Crisis?
Goldstein also sees reason for concern. “I do think there is underlying fragility, and I do think these events have exposed some of it,” he says. “It’s obviously hard to say whether we’re going to have a financial crisis of the same magnitude that we had in 2007-2008.”
One reason to think that might be avoidable even if growth slows is that the large banks that helped bring down the economy with risky bets on exotic debt instruments in the mid-2000s are in much better positions now. The five largest Wall Street banks held a combined $6.7 billion of corporate debt designated as illiquid and hard to value at the end of the third quarter, according to Bloomberg News. However, that total is less than 1% of their combined $803 billion in equity. Lehman Brothers Holdings alone carried $25.2 billion of similarly designated securities in its trading book at the end of 2007, topping its $21.4 billion in equity, Bloomberg reported.
Third Avenue is not a good yardstick for the health of the broader high-yield market because “it mismanaged the fund…. It’s not your typical high-yield bond fund.” –Leo Acheson
“The banks are very, very sound at this juncture,” noted Wharton finance professor Jeremy Siegel in a recent Knowledge at Wharton interview. The problems last year mainly had to do with energy companies falling into trouble as oil prices fell. Banks largely avoided the sector, he added, and there was plenty of other money in the market to pick up the slack. “This is very, very important, in contrast to 2007 and 2008.”
However, while banks were held back in part by new regulations, mutual funds in recent years increased their holdings of very illiquid assets, most specifically in thinly traded high-yield corporate bonds, as they chased returns in a slow-growth, low interest rate environment. Yet, Goldstein notes, these funds allow their investors to take money out on a daily basis. “They are offering investors a very high level of liquidity, but on the other hand, they’re holding assets that are illiquid.”
That could be a recipe for problems if the funds are hit with a growing wave of redemptions and can’t sell their holdings. Data from Lipper shows high-yield funds already had negative flows for seven of the 12 months of 2015, with investors pulling out a total $13.88 billion over the year, including $6.29 billion in December alone.
But while it’s unfortunate for shareholders when mutual funds encounter problems, the failures of a few funds likely won’t hurt the economy overall, says Richard Herring, also a Wharton finance professor. “I would argue that relative to the alternative of holding this debt in commercial banks, mutual funds are less likely to pose a systemic threat.”
There’s an important difference between recent problems at Third Avenue and the others, and the point in September 2008 when money market mutual funds were unable to redeem shares at the $1 per share value required at money market funds, Herring adds. “When the Prime Reserve Fund was unable to redeem its share and ‘broke the buck,’ this did have serious spill-over effects, because it cast doubt on the fundamental premise on which money market mutual funds were based.”
Illiquidity is a significant risk in managing a mutual fund, Herring adds, and Third Avenue’s redemption halt may jeopardize the firm’s ability to continue in the business. “But it need not — and indeed did not — cause closures at other high-yield funds.”
According to Siegel, the worst might be over. “I do not think that we are going to see a weakening of the high-yield market this year. In fact, there are probably some good values right now in that market.”
“The banks are very, very sound at this juncture. This is very important, in contrast to 2007 and 2008.” –Jeremy Siegel
Another indicator worth watching is the difference in rates for high-risk corporate debt and government securities. That difference, or spread, has been increasing of late, which some research suggests may be a signal of wider economic trouble ahead. If the spread between the rates on junk bonds and 10-year Treasuries — now at 7.03%, about 200 basis points higher than a year ago — were to continue rising, that could suggest that credit conditions were worsening and would be cause for greater concern among investors.
But while rising spreads are generally a concern, the concentration of problems in the energy sector makes the overall picture less worrisome than it otherwise might be, said Julianne Niemann, an analyst with Smith Moore. While some energy companies are in trouble, “the economy is not going down; there’s no risk for recession in sight. Most of what you’re seeing in the market right now is very instrument specific.” Given energy’s difficulties, she suggests the spreads should be even higher. “These guys have higher risk.”
Another Gauge to Watch
Analysts expect junk bond defaults to start rising this year and continue increasing through 2017, as the current stretch of below-average default rates is reaching the end of a typical cycle. Since the 1980s, low-default periods ran six years from 1985-1990; eight years from 1992-1999; and six years from 2003-2008, noted Standard & Poor’s Steve Miller, managing director for Leveraged Commentary and Data, who wrote that in surveys, “managers use many sports-driven metaphors to describe the current state of the credit cycle: late innings, the third period, the back nine, etc.”
Miller said that an unforeseen shock to the economy on the magnitude of the September 11, 2001, terror attacks or the Lehman Brothers bankruptcy in September 2008 could bring on a sudden spike in defaults, which could have a negative impact on the broader economy. “The potential for such an event today is hardly an idle concern given the long list of flash points around the globe,” he wrote, but outside such a blunt force, defaults will likely be confined to the energy and commodities sectors, along with a “smattering of names that are potential bankruptcy candidates.”
Morningstar’s Acheson agrees there are liquidity concerns across the high-yield sector, but that the biggest problems appear to be in energy and commodity companies. “It’s difficult to paint the entire sector with that broad of a brush,” he says, adding that it doesn’t appear likely that the problems in commodities will spread to the rest of the economy.
But despite the “worst case scenario” for energy, Acheson doesn’t see reason for great concern across the board. Banks and consumers are in much better condition than they were in 2007-2008, he notes. “A catastrophic meltdown doesn’t seem likely.”