Why High-Yield Debt Selloff Isn't 2007 All Over Again. Or Is It?

Is There a Fire Sale Starting in High-Yield Funds?
  • Analysts don't see contagion spreading as in financial crisis
  • Largest banks' corporate-debt inventories fell 20% this year

Wall Street is having a 2007 flashback as a high-yield debt rout triggers nightmares of hard-to-trade assets plunging in value and funds halting redemptions.

Jim Reid, a strategist at Deutsche Bank AG, wrote Monday that this month’s turmoil, including Third Avenue Management’s suspension of cash redemptions from a mutual fund that invested in high-yield debt, may be a harbinger of things to come. Berwyn Income Fund’s George Cipolloni said the similarities between markets now and those before the financial crisis are too big to ignore.

Get a grip, traders and analysts say: This isn’t the making of another financial crisis -- at least not yet.

“I don’t see any systemic risks out of this,” said Fred Cannon, a KBW Inc. bank analyst, likening the current situation more to the popping of the Internet bubble than to the credit crunch that crippled the financial system. “If this is a signal of a recession, then you have to believe any kind of downturn in the economy, as it relates to the large banks, will look a lot more like 2001 than 2008.”

Funds run by Third Avenue and Stone Lion Capital Partners have stopped returning cash to investors after clients sought to pull too much money as falling energy prices contributed to poor performance this year. In 2007, funds at Bear Stearns Cos. and BNP Paribas SA halted redemptions after the value of their subprime-mortgage investments plummeted. That served as a precursor to bigger losses and liquidity issues at major banks that hobbled the global economy over the next two years.

Five years after the Dodd-Frank Act, banks are better-capitalized and have smaller inventories of thinly traded debt, and the firms wouldn’t be materially affected by any contagion from declines in high-yield bonds, according to market participants. The broader impact will probably be felt by corporate America, which has relied on hungry debt markets over the past five years to extend financing cheaply and fund acquisitions, dividends and buybacks.

Trading books of the five largest Wall Street banks had a combined $6.7 billion of corporate debt at the end of September designated as Level 3 because it’s illiquid and hard to value. That’s less than 1 percent of their combined $803 billion in common equity. Lehman Brothers Holdings Inc. by itself had $25.2 billion of Level 3 mortgage- and asset-backed securities in its trading book at the end of 2007, a total that exceeded its $21.4 billion in equity.

Trimming Inventories

While tough trading environments can push more bonds into the Level 3 category, banks have continued their reduction of corporate-bond inventories this year amid stricter capital and liquidity rules. The five firms cut more than 20 percent of their corporate-debt holdings in the first nine month, a $27 billion drop. Those cuts limit exposure. They also have led to complaints from investors that it’s more difficult to trade some bonds.

“Dealer balance sheets are smaller, which does present liquidity challenges, but it also mitigates the risk that balance sheets have to contract significantly as occurred during the financial crisis,” Adam Richmond, a Morgan Stanley analyst, wrote in a note Monday.

The number of junk-debt funds that promise investors quick access to their money has exploded since September 2008 as zero interest rates spurred demand for higher returns. There are now 35 U.S.-based high-yield exchange-traded funds with $43 billion under management, compared with three funds with $1.3 billion in 2008, according to data compiled by Bloomberg. The number of mutual funds has grown to 252 from 100 in 2008 and assets increased to $326 billion from $126 billion.

Disorderly Withdrawal

The flood of retail investors has increased the likelihood that a withdrawal of money from high-yield could be quick and disorderly, said one trading executive at a global bank. The asset-management industry will probably use these recent collapses to examine the growing discrepancy between the liquidity of securities that funds invest in and the daily redemptions many offer, the trader said.

Just as many underestimated the effect that defaulting subprime mortgages would have on broader financial markets in 2008, investors pulling money from high-yield mutual funds could spread liquidity problems to more fundamentally sound parts of the financial system, said Michael Rosen, chief investment officer of Angeles Investment Advisors.

“It’s the wider implication that may force selling in other areas that may lead to a cascade of more selling and liquidity issues,” Rosen, whose firm advises on more than $25 billion, said in an interview from his office in Santa Monica, California. “That’s where the concern might be as opposed to there’s a run on distressed assets.”

The largest banks are also exposed to the high-yield decline through corporate-debt holdings in their investment portfolios and lending to credit-fund firms, which are often prime-brokerage clients. Several large asset managers, including BlackRock Inc. and Aberdeen Asset Management Plc, have increased credit lines this year to help meet redemptions if market liquidity is low.

Expecting More

While some investors said the turmoil, featuring a 9 percent drop in the SPDR Barclays High Yield Bond ETF in the seven weeks through Monday, would remain contained, others predicted more pain coming. After all, it took almost a year for Bear Stearns to collapse after it closed two funds.

“This isn’t going to be the big systemic unwind that everyone’s been waiting for,” said Jon Mawby, a London-based bond fund manager at Man Group Plc’s GLG unit, which oversees $31 billion of assets. “In my view, that comes with a lag of six to 12 months from now and will be caused by a bigger fund falling over.”

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