If investors were expecting a quiet week ahead of the December 16 Federal Open Market Committee (FOMC) interest rate decision, they did not get it. Light on macroeconomic releases, the week was marred by the sharp sell-off in most risk assets, sparked by the rout in oil prices and exacerbated by the fears of inadequate market liquidity.
On December 9, Third Avenue Management, a mutual fund firm founded in 1986, announced the liquidation of its high-yield bond fund and halted all investor redemptions. With approximately US$800 million under management, Third Avenue Focused Credit Fund is the largest fund to blow up since the financial crisis. While such an event would be a source of concern in and of itself, more troubling is the cause of its failure: insufficient liquidity. The fund had significant positions in illiquid securities and was unable to raise sufficient amounts of cash to meet the investor requests for redemption without selling its holding at deep discounts.
Liquidity in US credit markets has been on a steady decline since the Great Recession. A set of new post-crisis regulations aiming to improve bank safety has made it more difficult for large banks to hold corporate bonds on their balance sheets and to act as liquidity providers. This has been further complicated by the decline in the trading volume of single-name credit default swaps (CDS), which made it more expensive for the dealer banks to hedge their positions in cash bonds. It is emblematic that the recent marked declines in US corporate bond inventories of the banks resulted in net negative positions, for the first time ever. At the same time, the extended period of the low interest rate environment pushed the investors into riskier, higher-yielding assets, corporate bonds among them, while corporations increased their bond issuance in the hopes to lock in the low rates.
The somewhat paradoxical situation where both supply and demand increased, but the mechanism of matching the two directly became less efficient helped to increase the popularity of corporate bond exchange traded funds (ETFs). While many investors may be seduced by the convenience of these instruments, this week’s developments showed that the selling pressure that led to the demise of the Third Avenue Focused Credit Fund may also pose a serious threat to ETFs in spite of their diversified and passive nature.
In a stunning reversal over just one week, investors pulled a combined US$1.8 billion from two of the largest high-yield bond ETFs, SPDR Barclays High Yield Bond Fund (JNK) and iShares iBoxx US$ High Yield Corporate Bond Fund (HYG). This is roughly a third of the combined year-to-date inflows of approximately US$5 billion as of the start of this past week. These redemptions were concurrent with the general and sharp widening of spreads in all high-yield bond sectors. As oil prices fell to fresh cycle lows, debt issued by energy companies continued to decline significantly, but other sectors, most notably telecommunications and materials, were also sharply down.
The overall current level of distress in the high-yield bond market is clearly captured by the Markit CDX North American High Yield Index. As shown in the chart below, the CDS benchmark composed of 100 speculative-grade entities is nearly at its three-year high (Markit CDX North American High Yield Index for the period from August 2012 through 11 December 2015)
Source: Bloomberg, as of December 11, 2015