Monday, December 14, 2015

Will The High Yield Blow-Up Crash Markets?

Tim McLaughlin of Reuters reports, Third Avenue junk fund blow-up exposes risks of unsellable assets:
The blow-up of Third Avenue Management's junk bond fund this week, the biggest mutual fund failure since the financial crisis, show the dangers of loading up on risky assets that are hard to trade even in good times.

At least one-fifth of Third Avenue's Focused Credit Fund , with less than $1 billion under management, was composed of illiquid assets, meaning they trade so infrequently that they don't have a market price, according to a Reuters analysis. That's one of the highest percentages of exposure in the junk bond sector.

Meanwhile, some of the most popular U.S. junk bond funds also have made large bets on assets considered the hardest to trade and value in the industry, and their portfolios may not reflect the full extent of the current downturn in the junk bond market, said junk-bond analyst Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC.

"Precisely because these (assets) are hard to price, they won't necessarily show the full extent of the market decline," Fridson said. "That can make a fund with lots of illiquid security look better than a fund with big, liquid names where the price declines are very transparent."

AllianceBernstein's AB High Income Fund has the biggest holdings on a percentage basis this year among the largest junk bond funds. At the end of July, the fund reported $1.08 billion in illiquid assets, or 15 percent of the securities in a $7.3 billion portfolio, according to a Reuters analysis of the 10 largest U.S. junk bond funds. The Third Avenue fund isn't in the top ten.

AllianceBernstein did not respond to questions seeking comment.

With the $236 billion junk bond mutual fund sector on course for its worst performance in seven years due to a rout in commodity prices and expectations of higher interest rates, some big junk bond funds already are scaling back exposure to their riskiest assets.

The $17 billion American Funds High-Income Trust Fund , which this year realized nearly $200 million in losses on its most illiquid assets, told Reuters it plans to reduce its current exposure of 1.6 percent of securities that are hard to price and trade.

An American Funds spokesperson said the positions are carefully researched.

High yield, also known as junk, debt issuance has skyrocketed from $147 billion in 2009 to more than $300 billion in each of the last three years. Record-low interest rates have encouraged investors to take on more risk, including the debt of less creditworthy issuers, to get a higher return.

Tom Lapointe, portfolio manager of the Third Avenue fund, said in an October 2014 interview with Reuters that "any company with a pulse has been able to refinance."

In addition to AllianceBernstein and American Funds, other investment funds such as BlackRock Inc and Waddell & Reed Financial Inc have junk bond funds - staple holdings for pension funds, retirement plans and mom-and-pop investors - that hold the largest amount of assets that are so illiquid and so hard to price that their valuations are sometimes pegged to assumptions made by the investment managers themselves, their fund disclosures show.

REAL CARNAGE?

The illiquid debt favored by junk bond funds ranges from subprime loans bundled into mortgage-backed bonds by Wall Street banks on the eve of the credit crisis to bank loans to distressed companies in the energy and chemical industries.

Fund managers favor illiquid assets because they may pay 50 cents on the dollar to buy them, for example, and they get a yield premium for carrying the extra risk, said Sumit Desai, an analyst at fund research firm Morningstar Inc.

Most junk bond funds don't hold any so-called Level 3 assets, which are generally considered risky and illiquid, or the amounts are less than 1 percent of their portfolios, according to a Reuters analysis of fund disclosures.

Junk bond portfolio managers already are navigating a treacherous market featuring a meltdown in the energy sector. Managers say junk-bond pricing volatility is reminiscent of the 2008 financial crisis. And investors have made $5.7 billion in net withdrawals from junk bond mutual funds this year, according to data from Lipper Inc, a unit of Thomson Reuters.

DoubleLine Capital bond star Jeffrey Gundlach this week predicted "real carnage" in the junk bond market as the Federal Reserve leans toward raising interest rates for the first time in nearly a decade.

The sector is losing 3.01 percent this year, compared with 2008 when junk funds lost 25.5 percent, according to Lipper Inc data.

Fund assets are typically categorized as Level 3, according to U.S. accounting rules, when pricing is unavailable and their value is set by internal estimates or quotes from outside vendors. By contrast, U.S. government bonds or blue-chip stocks are categorized as more liquid Level 1 assets because their value is easily discovered in the market and they trade frequently.

Some funds with the highest percentage of Level 3 assets also are among the worst performers, according to Lipper.

Waddell & Reed's $6.7 billion Ivy High Income Fund ranked fifth worst with a one-month total return of negative 3.33 percent. The fund's Level 3 assets were almost $260 million at the end of September, or 4 percent of the portfolio. The company did not return messages seeking comment.

BlackRock declined to comment about its holdings.

"For stuff that's illiquid even under ordinary conditions, anyone who sells under present conditions will take a bath," Fridson said.
Tae Kim of CNBC also reports, Are Third Avenue woes a sign of the next crisis?:
Wall Street is buzzing on the news of a redemption halt and liquidation of a well-known high-yield bond mutual fund.

If a well-respected value investment firm with an impressive track record such as Marty Whitman's Third Avenue Management can suffer such a misstep, are many more, less notable investors next?

Given the sell-off in the stock and bond markets Friday, the market believes the answer to that question is "yes."

Third Avenue sent a letter to clients Wednesday stating the liquidation of the Focused Credit Fund (FCF) is to protect investors:
"Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF (Focused Credit Fund) going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders."
As of Wednesday, the Focused Credit Fund had $789 million in assets and returned a negative 27 percent year to date, according to Morningstar.

Noted bond fund manager Bill Gross of Janus Capital, formerly of Pimco, sees the news as a sign to take risk exposure down.

And Carl Icahn, Friday on CNBC's "Fast Money: Halftime Report," compared the junk bond market to a "keg of dynamite."

Other investors, however, think it is more of a one-off situation.

Brean Capital's Peter Tchir in an email to clients Friday explained the Focused Credit Fund was concentrated in the riskiest securities and may not be representative of the entire high-yield bond market with 50 percent of the fund in nonrated and 45 percent in CCC and below rated assets.

Jeremy Hill, managing partner of Old Blackheath agrees:
"Any time any fund closes redemptions it has to be a concern for the market. ... No matter what the manager claims, this is not about illiquidity. It's about pricing. The fund holds many publicly traded assets that currently have bids and offers. It's just that the manager doesn't want to sell at the prices offered, especially since the fund is already down 30 percent. ... That is not a reflection on bond market liquidity. That's manager judgment."
But Peter Kenny, an independent market strategist, believes the news has significant implications for market sentiment even if it's not indicative of the industry.

He wrote in an email: "Concern over bond market liquidity has emerged as a principal concern for analysts and investors alike in recent quarters. This closure may be a 'one off' but given the backdrop of concern on the Street, it will set off alarm bells and drive a heightened sense of bond-centric risk awareness. Certainly not a net positive for markets if this confirms a broader narrative."

The key takeaway may be not the liquidation itself, but what drove the underperformance of this fund.

A number of the fund's top 25 holdings are in the troubled energy and industrials sectors, according to Morningstar's website. As oil and commodity prices plunge in 2015, investors are becoming increasingly worried about the solvency of leveraged companies in those sectors.

The cost of buying default protection on the S&P 500 Energy Corporate Bond Index is up by 185 percent since May, according to S&P Dow Jones Indices.

Legendary energy trader John Arnold confirmed to CNBC Thursday that he expects half of U.S. energy companies to go bankrupt next year if oil prices do not rebound.

Investors are clearly starting to get worried about the meltdown in junk bonds. U.S. high-yield bond funds saw a net redemption of $3.5 billion from retail investors for the week ended Dec.9, according to Lipper.

S&P 500 vs. HYG YTD


Source: FactSet

The market in recent months diverged from the iShares iBoxx USD High Yield Corporate Bond ETF (HYG), but that changed this week. Another ETF tracking the asset class, the SPDR Barclays High Yield Bond ETF, is at it lowest level since the 2009 financial crisis.

"Debt-funded buybacks and mergers have been a massive source of demand for equities in recent years; a turn in the credit cycle has major implications for the broad stock market," Jesse Felder of the Felder Report wrote in an email.

Now 91, Whitman is operating as chairman of Third Avenue and all indications are he did not have a direct hand in managing assets in this particular fund.

If the drop in stocks Friday proved that Third Avenue's woes weren't priced into the market, a large default cycle by energy and industrial companies in 2016 certainly isn't accounted for either.
So, did the dreaded liquidity time bomb just explode and will it wreak havoc on markets? No, this is just another case of some mutual fund managers taking excessively dumb risks in credit markets, loading their portfolios up with the riskiest, most illiquid bonds and now that oil prices dropped to an 11-year low, the chickens have come home to roost.

However, I agree with Jeremy Hill, managing partner of Old Blackheath,  it's not about illiquidty, it's about pricing. There are some sharp investors on Wall Street investing in battered bonds at the right price, and now they'll have plenty of opportunities to continue doing so.

One of those investing in battered bonds through closed-end bond funds is Jeffrey Gundlach, the reigning bond king, who believes it's "unthinkable" that the Fed would want to raise rates with what's going on in the market now:
While most agree that the Fed will hike rates this week, not everyone is quite as sanguine about what's going on in the HY market.

"The entire existence of the high-yield bond market is during secularly declining rates," DoubleLine's Jeffrey Gundlach warned back in May.

And rates have effectively been in decline for three decades.

"I've got a simple message for you: It's a different world when the Fed is raising interest rates," Gundlach said last Tuesday. "Everybody needs to unwind trades at the same time, and it is a completely different environment for the market."

Gundlach believes it's "unthinkable" that the Fed would want to raise rates with what's going on in the market now.

"This is a little bit disconcerting that we're talking about raising interest rates with corporate credit tanking," Gundlach said.

Gundlach's warnings came days before HY spreads really started to blow out. In recent days, we've heard money managers like Third Avenue and Lucidus liquidate their credit funds because of what's happening.

Karoui doesn't believe the worst is over.

"The heavy redemptions, rock-bottom levels of risk tolerance, and persistent downside risk for oil prices will likely continue to weigh on HY," Karoui said.

Maybe the Fed will flinch. We'll find out on Wednesday at 2:00 p.m. ET when the Fed publishes its policy statement.
I don't believe the worst is over either because I don't see any end to the deflation supercycle and I agree with Gundlach, the Fed will be making a monumental mistake if it raises rates on Wednesday.

It's not just the credit markets that concern me, it's the surging greenback and an emerging markets crisis, especially if we get another Chinese Big Bang, but by all accounts the Fed is ready to go. Still, don't discount the possibility of a December surprise even if it means markets will tank (I will discuss the Fed's actions on Tuesday and why it's damned if it does and damned if it doesn't raise rates).

All year, I've been warning investors to steer clear of emerging markets (EEM), Chinese (FXI), Energy (XLE), Oil Services (OIH), Oil & Gas Exploration (XOP) and Metals & Mining (XME). These are the sectors that are suffering the most as the deflation supercycle keeps ravaging the global economy.

So, let me ask you, does it surprise you that some idiots who bought the riskiest bonds in some of these sectors are now getting killed and seeing massive redemptions in their high yield bond funds?

It shouldn't. Whether you manage a mutual fund, hedge fund or any fund, making money and losing money is all about taking the right risks at the right time. Some fund managers are going to make a lot of money in this high-yield blow-up while others are going to be eviscerated.

Now, exactly one year ago, I wrote a comment on why the plunge in oil will not crash markets where I stated the following:
The reality is the collapse in oil will rock some markets and economies a lot more than others. Brazil, Mexico, Russia and especially Venezuela, will be among the hardest hit, but the plunge in oil will also hit Canada, albeit nowhere near as badly.

In my opinion, the credit contagion arguments have been blown way out of proportion. To compare the contagion effects of the plunge in oil to that of the decline in the U.S. housing market between 2006-2008 is pure fantasy and sloppy investment analysis.

Make no mistake, the plunge in oil markets will not roil credit markets and cause another financial crisis anywhere near what we saw back in 2008. To even think this is ludicrous.

What is happening right now is a major shakeout in the energy industry which will likely last for years. As I've repeatedly argued, lower oil and commodity prices are here to stay, and those betting on a major recovery in energy (XLE), commodities (GSC), materials (XLB) and other sectors that benefited from the boom like industrials (XLI) are going to be waiting a very, very long time.

Will there be relief rallies? Absolutely, and they can be violent relief rallies, but the trend is inexorably down as global deflationary headwinds pick up. Also, in this environment, we will see a pickup in mergers and acquisitions activity and I await more deals like Halliburton's (HAL) acquisition of Baker Hughes (BHI) and Repsol's recent bid for Talisman Energy (TLM).

As I've repeatedly argued, the biggest risk for stocks in 2015 is a major melt-up unlike anything you've ever seen before. The plunge in oil will do nothing to stop this. Markets can easily take off even if oil and commodity prices stay low (financials, retail, healthcare and technology make up a bigger proportion of the S&P 500 than energy, materials and industrials).

Are there going to be corrections along the way and unforeseen or even foreseen black swans that will cause major disruptions? Sure but in my opinion, the only thing that can derail this endless rally is a significant pickup in global deflationary headwinds.

And if deflation does hit America, that's when you'll see central banks really panic, putting an end to the old adage, "Don't fight the Fed." In my opinion, even though this time is indeed different, we are not yet at the precipice of a total, systemic loss of confidence. There is still plenty of liquidity and faith in central banks to drive risk assets much, much higher. You just have to be careful before plunging into stocks or you risk getting slaughtered.
Well, following China's Big Bang, global deflationary headwinds picked up significantly and we didn't get any "melt-up in stocks." And now we're seeing a blow-up in some sectors in the U.S. credit markets and that's making investors uneasy, especially if the Fed starts raising rates.

But I caution you to be very careful here and not assume this latest high-yield "blow-up" will crash markets. Some sectors of this market are not going to be able to get debt financing. They might go to hedge funds or private equity funds which specialize in distressed debt or they might go to a pension fund like PSP Investments which is ramping up its leveraged finance business and has a much longer investment horizon than hedge funds or private equity funds.

Most highly levered companies in energy and commodities aren't going to survive this deflation supercycle. They'll be forced to issue more and more equity (diluting their shares) and when that game runs out, they're going to go bankrupt and die.

Will this have an impact on credit markets? Of course it will but there's a lot of hysteria out there which is not grounded on solid analysis and too many investors are throwing the baby out with the bathwater, which will present great opportunities for the sharpest investors in 2016.

Below, Martin Fridson, Lehmann Livian Fridson Advisors, sees no signs of a recession and talks about distressed bonds and the market selloff. Smart guy, listen to his comments before you read too much into this latest high-yield blow-up.




No comments:

Post a Comment