Wall Street is freaking out.
The market for high-yield bonds and the closure of the Third Avenue Focused Credit fund is, depending on who you ask: historic, scary, a keg of dynamite, full of landmines or likely to cascade into something bigger.
To recap, high-yield bonds (or those of riskier borrowers) have sold off sharply.
The declines began among bonds in the energy sector, as investors worried that tumbling oil prices would make it hard for borrowers to pay back their debt, but the concern has spread from there.
Then, last week, Third Avenue announced plans to liquidate its Focused Credit fund, and said it would freeze withdrawals because it is unable to exit positions quickly. That got other investors worried about their ability to get out of the market, creating even more selling pressure.
Now the market is tanking, and the high-yield market – a place many investors had put extra cash as they looked for yield in a low-interest rate environment – is set for a historic year.
“2015 could become the worst non-recession year for HY,” Goldman Sachs’ Lofti Karoui said in a note today. “HY returns have sunk to their lowest level on the year as the pressure from lower oil prices continues to constrain risk appetite.”
It feels like everyone on Wall Street is now voicing concern:
Citigroup said on Friday that the bond market was littered with landmines.
Societe Generale said in a note Monday that the Third Avenue decision to close its fund was “sending shivers through a market which still remembers the events of August 2007 when BNP froze withdrawals from three of its funds.”
Scott Minerd, global chief investment officer at Guggenheim Partners, told Bloomberg that more high-yield funds will face investor redemptions.
“The risk is that this is going to cascade into something bigger,” he said.
Ryan Wibberley, chief executive of CIC Wealth, echoed those sentiments when talking The Wall Street Journal.
“I’m not normally a doom-and-gloom type of guy, but this is scary,” he said.
Carl Icahn said last week on CNBC that the high-yield market “is just a keg of dynamite that sooner or later will blow up.”
And then there is this from Bill Gross:
Gross: HY Fund closes exit doors. Who will get in if you can’t get out? Risk off.
— Janus Capital (@JanusCapital) December 11, 2015
The background to this is that the high-yield market has boomed since the financial crisis. As the chart from UBS below shows, issuance in the US high yield market has exploded since 2007. Investors have poured money into high-yield mutual funds and exchange-traded funds offering daily liquidity in an asset class that has become increasingly difficult to trade.
The key issue here is whether you think we are at the beginning, or the end, of the credit cycle, and whether the sell-off says anything about the economy, or is more technical in nature.
Clearly, many see this as the beginning of a downturn in the high-yield market. The expect things to deteriorate fast from here, and that a recession may be just around the corner.
There are also those who think we’re in the latter stages of a sell-off, and that it doesn’t say a great deal about the economy. Deutsche Bank strategists said in a note on Monday for example:
With CCC energy bonds trading at 60 cents on the dollar, and oil just $10 away from matching the most severe percentage drop in oil prices over 1997-8, our sense is that we may be reaching the latter stages of a pronounced move lower in a commodities-driven decline in HY credit valuations.
And here is Goldman:
IG and HY spreads have been sending strong recession signals over the past several months, oscillating around their third historical quartiles. In our view spreads are sending a false recession signal.
Time will tell.