Junk bond volatility: potential crisis or par for the course?

The narrative around junk bonds has become familiar: in an ultra-low interest-rate environment, yield-starved income investors shift from safer, lower volatility securities into riskier, more volatile ones. This works well enough until rates start rising, which can lead to significant principal loss in the overheated sector. The potential result is a stampede out of high-yield bonds that leads to wider spreads, higher corporate default rates and potential liquidity problems. Coming into this year, that pin had not yet dropped in a meaningful way as bonds had remained in a thirty-year secular bull market. But with the Federal Reserve lifting off 0% interest rates, we are set to enter an unusual environment for the junk bond market.

The following Episode Feature appears in the December 20, 2015 issue of the Wall Street Week Newsletter. Subscribe – it’s free.

As spreads between non-investment grade corporate debt and risk-free US treasuries remained unusually tight in the first half of this year, the cavalry of talking heads warned about the dangers of owning junk bonds at current prices. The platforms for such warnings included Wall Street Week, where the first and third guests of the show’s reboot – Jeffrey Gundlach and Carl Icahn – recommended investors take a hard look at junk bond exposure in their portfolios. Over the past two weeks, as the market braced for and endured the first interest rate hike in nine years, we seemingly got a glimpse of what those doomsday fears could look like. The trillion dollar question is whether recent volatility in junk bonds is simply a natural credit cycle phenomenon that can be absorbed within current market structure, or represents a potential catalyst for systemic failure.

The event that got people talking about a potential crisis last week involved Third Avenue Management’s $788 million Focused Credit Fund. The open-end junk bond fund, after losing 27% this year, informed investors it wouldblock redemptions and put assets in a liquidating trust in order to avoid selling them at depressed prices. The announcement underscored concerns about the liquidity mismatch between high-yield bond mutual funds, which offer daily liquidity, and the assets comprising them, which, because of their low quality, may be less liquid – especially during market turmoil. The news also set off alarm bells in the investment community regarding the liquidity of the entire junk bond market.

When the news first hit, it smelled to some like the closure of two Bear Stearns mortgage-backed security (MBS) funds in 2007, but once analysts got a chance to dig deeper into the situation at Third Avenue, it became increasingly apparent the two situations had little in common. For starters, the composition of Third Avenue’s Focused Credit Fund was highly, to put it mildly, unique within the junk bond space.

Junks bonds are categorized as bonds that carry a credit rating of BB or below from Standard & Poor’s, or ‘Ba’ or below from Moody’s. Not all junk bonds are created equal; there can be significant divergence between the quality of credits within the upper and lower part of the junk bond spectrum. The Third Avenue Focused Credit Fund, which at its peak had $2.5 billion AUM, could at one time have been described as a high-yield fund, but after years of deterioration in the quality of its credits had long since morphed into a distressed credit fund. Distressed credits have no business operating in a mutual fund structure because of their extreme underlying illiquidity.

While most corporate bond funds are highly diversified, Third Avenue’s portfolio was highly concentrated. The top 10 holdings comprised more than 25%, and the top 50 holdings around 75%, of the fund’s assets under management (AUM). The fund was also scraping the bottom of the barrel in terms of credit quality.For perspective, the average credits in a high-yield bond fund are priced at 90 against par and yield 8.6%. But Third Avenue’s bonds were lower-rated credits, so it’s easier to compare apples to apples – CCC rated bonds are the lowest rung on the junk bond ladder. Even relative to other CCC bonds, the quality of the assets in the Third Avenue portfolio were poor. The average price, against par, of Third Avenue’s top 50 holdings was 54, whereas the average price in the Merrill Lynch CCC & Lower US High Yield Index is 68. The average yield on Third Avenue bonds was 38%, versus 17% for the index. Even more alarming is the fact that in a low default rate environment between 2013 and 2015, 15 credits within the Third Avenue fund had undergone restructuring.

Third Avenue may not initially have set out to create a distressed bond fund, but by late 2015 that is what the fund became. The ratio of credit downgrades to upgrades within the junk bond space this year has been two to one, the highest level since 2009, in large part due to the underperformance of energy-related debt. This wave of downgrades pushed bonds that previously fell in the high-yield spectrum into the distressed category, and Third Avenue elected not to do housekeeping on its portfolio. Janet Yellen said about Third Avenue, when asked in her post-rate decision press conference, that it was a “rather unusual open-end mutual fund… [with] very concentrated positions in especially risky and illiquid bonds.”

Not only was Third Avenue a special case within high-yield, but the potential for systemic shocks within the junk bond market is much less than it was for mortgage-related funds in 2007. While financial regulation, namely the Volcker Rule in Dodd-Frank, following the 2008 crisis reduced the number of counter parties to absorb liquidity during periods of market turmoil, it also migrated credit risk from banks to buy-side investors. While investors could experience heavy losses in a bond market sell-off, big banks no longer carry systemically dangerous levels of exposure – which was the purpose of the legislation. At the end of the third quarter, the five largest Wall Street banks had a combined $6.7 billion of Level 3 debt, categorized as debt that is highly illiquid and hard to value, representing less than 1% of those banks’ combined equity. At the end of 2007, Lehman Brothers alone carried more than $25 billion of Level 3 debt, which actually exceeded the firm’s equity of around $21 billion!

In addition, the high-yield bond funds in question today do not use leverage at all, whereas in the financial crisis, funds run by the likes Bear Stearns and Lehman Brothers were levered up anywhere from 10 to 30 times. In the 2008 crisis, levered sellers were climbing over levered sellers attempting to unload worthless assets. Today, despite there being fewer institutional market makers, the risks in a bond market rout are more symmetrical.

While Icahn has also decried the growth of fixed income exchange-traded funds (ETF), over the past two weeks liquid ETFs and closed-end funds actually demonstrated a much greater capacity to cope with volatility than open-end funds. When liquidity fears drive prices of ETFs below net asset value (NAV), intraday price discovery allows investors to come in and buy them. Last Friday, Blackrock’s iShares iBoxx $ High Yield Corporate Bond ETF (HYG) traded more than four times the record daily volume of any fixed income ETF in history, and functioned just as intended with ample liquidity.

Even recent critics of junk bond valuations viewed the recent dislocation as a buying opportunity. In early December, Howard Marks, founder of Oaktree Capital, the biggest distressed debt investor in the world, called opportunities in junk bonds the most attractive he’d seen in years, noting the Third Avenue event was “a function of one fund’s management, not weakness of a whole asset class.” Bill Gross, the former PIMCO “bond king” and current fund manager at Janus, said the high-yield space was “loaded with bargains.” The market backed up their assertions, as Tuesday and Wednesday the junk bond ETF HYG quickly snapped back to erase much of the prior week’s losses before turning lower again following the Fed rate hike.

While a crisis may have been averted in the short-term, the tide within the junk bond market is clearly shifting. Investors, increasingly aware of their high-yield bond exposure, withdrew $5 billion from junk bonds last week, the largest outflow since 2011. The asset reallocation is a natural phenomenon. Legendary investor Wilbur Ross echoed Gundlach’s concernsabout the rolling tsunami of corporate bond maturities starting in 2018, which could lead to default rates beyond the context of the 4% thirty-year average. The template for a junk bond market cataclysm is there, but for now the much-maligned modern market appears equipped to handle a little garden-variety cyclical volatility.