It is obvious from Friday’s market action that the end is nigh, or we are on the “eve of destruction”: or better yet, stock market Armageddon has arrived. What tripped this all off? A well-respected value manager, Marty Whitman and his firm Third Avenue Management got themselves a little bit too far out over their skis with the high-yield (junk) bond assets they run, including Focus Credit Fund (FCF). The firm, which at one time boasted assets under management (AUM) of $3.5 billion, had not performed well and was suffering redemptions … so-much-so, AUM had declined to $800 million. Because of liquidity issues in the high yield market, Third Avenue took the unprecedented action of halting redemptions in FCF… a real shocker.
According to Martin Fridson, CIO Lehman, Livian, Frisson Advisors, LLC., the portfolio was at the very top of the risk spectrum; ergo, very illiquid. Third Avenue has decided that it is in the best interest of all its investors to put a moratorium on redemptions for the time being to allow for the extra time it will take to dispose of these one-of-a-kind, high-risk assets. Remember, this is not like buying a stock, where every share of General Motors is exactly the same as the next. Each one of these bonds has a set of unique covenants and characteristics that may have appeal to only specific buyers. There may not be a buyer there when an institution wishes to sell. This is obviously very problematic for mutual funds, even more-so for the sponsors of exchange traded funds (ETFs) that specialize in high yield securities…because the sponsors would be responsible for warehousing the bonds in the absence of active bidders in the street.
Fear of Contagion–Systemic Risk
To the point, Blackrock, for example, has over $4.5 trillion in assets under management. As part of this, they sponsor mutual funds and ETFs that invest in high-yield securities. What would be the impact of Blackrock and others having to eat (or even value for sale) a portfolio of illiquid, highly-levered securities? What would be the potential collateral damage? It is hard to speculate on this, but the media is working hard to spin this into the mortgage-backed securities crisis of 2008. This appears to be a real stretch.
According to HighYieldBond.com, the high-yield/junk bond segment of the $8.1 trillion corporate bond market is about 15% or $1.2 trillion in size. According to Morgan Stanley, approximately 13.5% ($162 billion) of the $1.2 trillion is energy related. Admittedly energy is a disaster. At $35.36/barrel on West Texas intermediate (WTI) there is tremendous stress on that part of the market. The most stressed part of energy would be the debt of independent producers and oil field service providers (about 2/3 of energy or $110 billion). If all this goes under (which is unlikely) it represents less than 1.5% of total corporate debt. If Blackrock owned all of these assets, it would hurt: but, again, if it were a total write off it would amount to less than 2.4% of their AUM … taxing, but hardly systemic in my view.
What about the rest of High-Yield?
Interestingly, after all the fear and angst generated about the high-yield market in the last 24 hours, one needs to ask what is really happening in terms of defaults — is this a major credit event in the making? Interestingly, defaults are running well below normal at 2.9% (normal = 4.6%). According to high-yield maven, Fridson, the high-yield market appears to be discounting a 6% default rate, while Moody’s is forecasting only 2.7% defaults in the next 12 months. Fridson explains this disconnect as an increase in risk premium required because of the lack of liquidity in the market. He believes you need a recession, which he does not see, to get defaults up to 6%. One inane conclusion of the media is that next week’s potential 25 basis point increase in the Fed Funds rate might drive high-yield and the economy off the cliff…ridiculous. For a really good explanation of what is going on in the the high-yield sector of the debt market, I’m providing links to two excellent clips from a CNBC interview with Martin Fridson. They are worth your time. (Fridson I) (Fridson II)
Carl Icahn must be big-time net short
He always appears to show up on days when the market is in extreme stress and the viability of high yield is in question with something like this little gem: “The high-yield market is just a keg of dynamite that sooner or later will blow up.” He did the same thing back on October 1, when he issued his “Danger Ahead” video (I commented in “Help! Plus more piling on”)
A few thoughts as we approach Fed-Day
- The 10-year UST yield peaked in December of 2013 at 3% (the announced beginning of the “tapering” of Quantitative Easing). Recently with the threat of a potential rate increase it has been no higher than 2.5%. It closed at 2.13%, Friday December 11, as the “fear” trade was clearly in place. A quarter point bump in the FF rate at this point will only reinforce the fear trade. It is, therefore, very unlikely that this increase will have any major negative effect on long-term interest rates. WHEN THE MARKET FIGURES THIS OUT, AND IF THE STATEMENT IS “ONE AND DONE” / “SLOW AND LOW”, I BELIEVE THE ENVIRONMENT FOR STOCKS BECOMES VERY POSITIVE.
- The dollar was supposed to strengthen when the Fed raised rates… making U.S. goods more expensive in international markets. Now, with this increase being viewed by many as a fait accompli, the dollar has declined over 4.5% from its recent high, even in the wake of Janet Yellin’s hawkish commentary two weeks ago.
- The absolute positive that $35/$40 a barrel oil brings to everyone, but the producers, has been totally missed in the rhetoric. It is there and working for all individuals and the energy consuming economies they live in. Remember, the prices of oil and many other commodities are down because of oversupply, not because the global economy has ceased to grow.
- Tax selling, some of which has been panic selling, has created significant opportunities in levered sectors of the market–MLPs, BDCs, REITs, Utilities and even Distressed Debt (don’t confuse illiquidity with viability).
- Since I began this post, another fund, a hedge fund Stone Lion ($1.3 billion in AUM, $400 million distressed debt), has suspended redemptions. This is not likely to play well Monday morning. It is important to remember the message in Fridson I and II. Default rates on high yield bonds are extremely low at present (2.9%). It would take a recession (which does not appear to be in the cards right now) to get to 6%, which means at a historical worst-case, 94% of the credits do not default. Ergo, this collapse may be setting the table with some real opportunities.
What Could Go Wrong?
If the Fed delays the rate increase because of the craziness going on in the high yield and commodity markets, we have a real problem. It will signal that the Fed thinks our economy and the world is too weak to withstand even a minor financial dust-up. Even worse, it will mean that the financial media and pundits with their fear mongering will have gained control of U.S. monetary policy. Please, Janet, say it ain’t so.
What are your thoughts?
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