It has started. Junk bond investors are running for the hills. But there are no hills.
Suddenly there’s a laundry list of what went wrong. A “more hawkish Fed stance, heightened geopolitical risks,” Argentina’s default, another bank collapse and panicky bailout in Europe (Banco Espirito Santo), “and concerns over stretched valuations,” wrote Matthew Mish and Thibault Colle of the UBS Global Macro Team; it triggered “a cascade of mutual fund outflows in recent weeks.”
They weren’t exaggerating. In the latest week, investors yanked $7.1 billion out of junk bond funds, a record amount, according to Lipper. This has been going on since early July, and junk bond prices have dropped, yields have jumped from all-time lows, and yield spreads have suddenly widened. After having been inflated to dizzying proportions, the junk-bond bubble has been pricked. And the hot air is hissing out of it.
This chart by UBS is a picture of investors suddenly bailing out while they still can. The vicious taper tantrum of last summer looks comparatively tame:
Neither glorious economic fundamentals nor corporate financial engineering caused investors to pile helter-skelter, eyes-closed into this high-yield junk. The Fed’s financial repression did.
The Fed has made it impossible for yield investors to earn a noticeable return above the rate of inflation with low-risk paper. So they chased after whatever yield they could get and they held their noses and ventured deeper and deeper into a swamp they normally wouldn’t want to be in. They did that in unison. The demand they created for junk drove up valuations and repressed yields further into low-yield purgatory, where potential losses are huge and potential gains very meager. Exactly as the Fed had wanted them to.
But the Fed has changed its mind. And it’s communicating it on a near daily basis [read… Fed’s Fisher: End of ZIRP moved ‘further forward’]. The force that has driven up the junk bond market and that has allowed overleveraged corporations to sell a mountain of junk bonds at record low cost is in the process of disappearing: QE will be tapered out of existence this fall; ZIRP will be whittled down later. Instead of the Fed’s free money flowing into the high-yield market, money is now draining out of it.
In this chart by UBS, the cumulative junk-bond fund flows (light-gray line, left scale) ballooned in parallel with the Fed’s balance sheet (dark line, right scale). But look at the top right-hand corner: as the dark line is flattening out, the light-gray line broke off like a dry twig.
In their note – chillingly titled, “Is the US high yield bond theatre on fire?” – the authors warn that investors “no longer have the Fed at their back,” just when “corporate leverage has bottomed as profits move sideways while net debt rises.”
As spooked investors – many of them conservative yield investors driven into junk bonds by the Fed’s relentless financial repression – are trying to dump their holdings before everyone else does, the problem of market liquidity arises: it has been evaporating.
Junk bond assets in mutual funds and ETFs have nearly tripled since the bottom of the financial crisis, while inventories at dealers have collapsed as many of the big banks have largely withdrawn from the fray. Market makers packed up their marbles and went home, while companies sold dizzying amounts of new junk debt at record high prices to investors blinded by the Fed’s financial repression.
So when these spooked investors are trying to sell, who is going to buy? Yields are still near historic lows, after nearly six years of QE and ZIRP that are now drawing to an end. But higher yields and lower prices – and higher default rates, according to Fitch – are lined up into the horizon as far as the eye can see. There are not going to be a lot of eager buyers.
“Simply put, one cannot enter and exit positions freely,” the authors explained with razor-sharp calm. Instead, investors are stuck and become “more buy-and-hold in nature.” In doing so, they could get hosed.
This arguably creates a prisoner’s dilemma. Investors have a choice. If they do not sell, and others do not sell, then market stability will likely result and historically low valuations could persist for a while longer. However, given challenging liquidity conditions and warnings from the Fed and others of a market ‘bubble,’ investors cannot overstay their welcome. If some of them decide to sell, then they can hope to exit before others – but risk causing a stampede of outflows.
And that stampede has already started. UBS sees “few signs of stabilization.” Instead, “headline risk will persist around the Fed’s stance as it finishes tapering and has to outline its exit strategy….” Eurozone banks are facing the ECB’s stress tests, and results will likely be out in October or November. And the asset allocation strategists at UBS “are tactically calling for a bout of risk-off.”
But the current turmoil in the junk bond market is just some preliminary pushing and shoving.
The real panic will come with a more severe downturn in credit and economic fundamentals, which will likely trigger an exodus from non-institutional and crossover/tourists from US high yield. That moment is unlikely to be a 2014 event….
OK, so maybe not this year. Unless everybody is afraid to wait till next year and starts selling now to be among the first ones out. Because everyone knows that in bond funds, the first ones out win.
When redemptions start as prices fall, funds dip into cash and sell the most liquid bonds that have lost the least value, and the first batch of investors get out scot-free. As redemptions continue, the less liquid bonds have to be sold into an illiquid market, and prices plunge. Junk-bond funds that get hit by massive redemptions over a long period of time can punish the late sellers – the forced “buy-and-hold” investors – brutally. That’s the effect of the “prisoner dilemma.”
And since everyone knows this, investors might be trying to get out early, thus triggering the very event – the “stampede of outflows” – that will punish investors behind them the most.