First published: 14th December 2015
In less than a week, three high yield – or what we should call junk – bond funds have succumbed to stress or closed down. Last week, Third Avenue Management told investors it had stopped redemptions on its $788 million HY mutual fund. Stone Lion Capital Partners, a hedge fund, did the same with a $400 million credit fund. Today, Lucidus Capital Partners, set up only in 2009, liquidated its entire HY fund and returned funds to investors.
HY spreads have been widening steadily for over a year, and in particular since the beginning of November, since when spreads have widened by 150 basis points.Credit default swap rates have risen in tandem. Reports suggest over $3.5 billion of redemptions last week as what started as a shake-out in the beleaguered oil and gas and mining sectors spilled over into other industrial sectors hitherto barely affected.
This isn’t quite the hors d’oeuvre to a decision to raise interest rates for the first time in a decade that the FOMC might have wanted, but it nevertheless captures the Fed’s rocks and hard places quite poignantly. Economic conditions forming the backdrop to the decision are quite unusual, but at the same time, the Fed’s zero rate policy (ZIRP) fingerprints are all over the HY bubble that’s going pop. Here is a market that, along with leveraged loans, had a capitalisation of less than a trillion dollars before the financial crisis, and is now running at about $2.2 trillion, its growth spurred by the ZIRP regime and the promise of high yields and returns.
So, how serious is this and will it, should it weigh on the Fed? Are high yield bonds the contemporary equivalent of mortgage backed securities in 2007-08?
Here is a reasonable FT write-up as to why the consequences of what’s been going on in the mutual fund sector at least may not be the leading edge of a major panic. Essentially, no one should really be spooked by the prospect of investors losing money from having taken risks that didn’t work out.
But it’s the secondary consequences that aren’t immediately visible that do warrant scrutiny. When redemptions from any particular fund start, there’s a danger of contagion, as we have started to see in the last few weeks. When funds fail, as highlighted above, there’s a high probability that banks tighten funding and lending conditions indiscriminately. When companies in the high yield sector come to refinance their obligations – and about $1 trillion fall due by 2020 according to recent work by UBS, though less than $50 billion in 2016 – financing conditions could be much tougher if the Fed is expected to continue raising interest rates.
The refinancing burden is spread out over a few years but what this particular issue helps to highlight is the activities of less than investment grade companies, which lie behind the surge in debt issuance during these last years of ZIRP. Although energy and mining companies have been identified as the major sectoral problem, the debt issuance has been far more generic. Financial engineering strategies to enable corporate acquisitions to convince investors of future earnings, borrowing to finance share buybacks and acquisitions that have undermined balance sheet resilience, and other ways of obfuscating true earnings performance have figured as prominent reasons. ZIRP has unquestionably been the key enabling factor, and enticed investors, keen to cash in on high returns – though this year, those returns have turned into losses as energy prices have fallen, and financial conditions have deteriorated.
Hence the angst about the Fed starting a process this week in which financing costs will rise, and high yield asset values decline further. The immediate danger of course is that turbulence for companies in the HY sector spills over into the prices of financial products such as ETFs that suddenly become illiquid, and of their common stock. The slightly longer horizon danger is that financial disturbances for companies end up curtailing their investment – over and above the sharp falls in energy capex already baked in the cake.
These concerns can’t be dismissed lightly, and there’s no question that the regulators will need to watch carefully asset management companies that have sold HY bonds and ETFs aggressively in the last years. But nor should they deter the Fed from embarking on the course that it seems likely to begin this week. Higher rates are part of the toolkit of financial stability, perverse though that may sound to finance professionals. Financial market volatility and re-pricing are par for the course and an occupational hazard. For the rest of us, the concern would be if they risk durable economic damage. Under those circumstances, the Fed might be derailed. But right now, today’s HY or junk problem doesn’t look like the mortgage-backed security problem of 2007-08.