Junk bonds experienced their steepest losses since 2011 after Third Avenue Management liquidated their $789 million Focused Credit Fund.
After the Great Recession, investors began pouring billions of dollars into junk bond funds to generate an income amid record low interest rates. These dynamics provided low-rated companies with easy access to capital that only expanded over time as rates remained depressed. Unfortunately, the easy access helped undeserving companies leverage up their balance sheets and may have set the stage for a collapse in the market.
The first cracks have begun to emerge following the dramatic slide in commodities, including the 42% fall in crude oil prices so far this year. With a 15% share of the junk bond market, energy sector defaults took a significant toll on mutual funds, ETFs and hedge funds holding them. These effects were amplified by metals and mining companies that hold roughly the same market share and have experienced similar defaults amid low prices.
The key questions for investors are whether or not these defaults will prompt a liquidity crisis in funds and whether or not the problems run deeper than the energy and metals markets.
Liquidity Issues
Third Avenue’s decision to halt redemptions in its high-yield mutual fund stems from a lack of liquidity more than anything else. In other words, the company was unable to sell bonds quickly enough to meet investor demands for cash without selling the debt at fire-sale prices. These events led many investors to question whether or not there was still demand for high-yield junk bonds in a market with rising interest rates and defaults.
It turns out that Third Avenue’s Focused Credit Fund is a bit of a unique story. Unlike traditional junk bond funds, the firm was focused primarily on companies in the process of restructuring or in bankruptcy proceedings, or in distressed debt. More than half of the fund’s holdings were unrated by credit agencies, while much of the remainder held CCC ratings. These elements make it unique among high-yield mutual funds in the space.
The iShares High Yield Corporate Bond ETF (HYG ), for example, has plenty of liquidity for investors, with a record $9.8 billion trading hands in recent weeks. According to BlackRock’s Peter Fisher in comments to CNBC, “We had 4.5 billion almost in volume just in BlackRock’s HYG high yield…on Friday,” adding that the cash market has just six to nine billion trading hands on a normal day and implying there’s sufficient liquidity.
Deeper Problems
Others believe that the problem with junk bonds may be bigger than oil.
“The high-yield market is just a keg of dynamite that sooner or later will blow up,” said billionaire investor Carl Icahn in a CNBC interview.
Many of these investors point to the $2.5 trillion in debt held by junk-rated companies in the U.S., including about $1.5 trillion set to mature over the next five years, according to S&P. If the economy shows signs of weakness and interest rates continue to rise, these companies could have a hard time restructuring that debt and the interest payments could take a toll on profits. Investors taking out capital doesn’t help either since it increases borrowing costs.
These debts are held by a number of different companies across retail, food, telecom, and semiconductor industries, including well-known names like Advanced Micro Devices (AMD) and Sears Holdings Corp. (SHLD). In some cases, these debts may be unsustainable and could prompt further defaults outside of the energy sector. The companies may also be susceptible to external market shocks that influence liquidity.
The Bottom Line
Third Avenue’s Focused Credit Fund collapse spooked the high-yield bond market, but the problems may be isolated to distressed debt at the moment. While liquidity remains ample for many traditional junk bond funds, there is a large amount of high-yield debt coming due over the next five years that may require strong earnings growth to service. This could make the asset class susceptible in the event of a downturn or unexpected market shock.
