Wall Street Weighs in on the Recent Tumult in the Credit Market
The fallout in credit markets is continuing to grab headlines this week with Lucidus Capital Partners, a high-yield credit fund, announcing that it has liquidated its entire portfolio and plans to return the $900 million it has under management to investors next month.
Last week two other creditfunds, a $788 million mutual fund run by Third Avenue Management and a $400 million hedge fund managed by Stone Lion Capital Partners, suspended redemptions in the face of heavy outflows. The SPDR Barclays High Yield Bond ETF, a proxy for the junk-bond market, fell the most in four years on Friday.
Of course, this means that Wall Street analysts have a thing or two to say about the recent tumult.
Here's a roundup:
Goldman Sachs' David Kostin:
"Weakness in the high yield credit market has spurred investors to ask what the relatively sanguine equity market is missing. We believe that credit is sending a false recession signal. Liquidity is a challenge for credit markets but not equities. Large concentration in commodity-exposed sectors has contributed to the -6 percent year-to-date high-yield credit return. A handful of narrow-breadth equity leaders have helped support the S&P 500 zero percent total return while the median stock returned -2 percent. However, U.S. corporate credit quality has deteriorated to the weakest level in a decade. Our strong balance sheet basket should continue to outperform as the Fed hikes."
CreditSights' Glenn Reynolds and Nathan Wenger:
"The Third Avenue redemption headline (followed by a credit hedge funds news item over the weekend) made itself felt in Friday trading activity as the specter of illiquidity in high-yield bonds gets a lot closer to translating into some more cataclysmic pricing scenarios in troubled pockets of high-yield ... Despite such few data points, the fear will remain that there are even more of such situations that could rear up from more traditional redemption problem channels (i.e. hedge funds) with some of the top players here at risk of making it a trend."
Goldman Sachs' Lotfi Karoui:
"High-yield returns have sunk to their lowest level on the year as the pressure from lower oil prices continues to constrain risk appetite. As we go to press, the HYG ETF is down roughly 5 percentyear-to-date. If the weakness persists until the end of the year, 2015 could become the worst non-recession year for high-yield...The heavy redemptions, rock-bottom levels of risk tolerance, and persistent downside risk for oil prices will likely continue to weigh on high-yield ... With only a small fraction of leveraged finance debt maturing by the end of 2018, refi[nancing] risk post-liftoff remains low. History also suggests the inability to refinance debt is not the only driver of defaults. The majority of corporate defaults are strategic in nature.
Bank of America's Hans Mikkelsen:
Clearly the case of TFCIX suspending redemptions and liquidating serves as a reminder of the dangers of mutual funds and ETFs owning inherently illiquid corporate bonds. In this particular case underperformance since the summer of 2014 created large outflows for about a-year-and-a-half ... While the magnitude of underperformance suggests this fund originally held bonds riskier than the overall market, at the tail end of large outflows clearly the fund appears to have exhausted any liquid part of its portfolio and was left holding a portfolio of concentrated positions in illiquid low rated high yield bonds ... While again this serves as an important reminder of the dangers of bond funds and ETFs, clearly this particular fund’s problems are idiosyncratic and by no means reflect on broader issues in the market at this point. However, obviously the risk imbedded in bond funds and ETFs is that over time more funds will find themselves in the same situation. For investment grade the risk that could trigger that scenario is upside risk to global growth and inflation, not downside risk unless that triggers a recession as – unlike for high yield - interest rate declines offset spread widening and keep prices relatively flat.
Deutsche Bank's Jim Reid:
So straight to the U.S. high-yield news. For sentiment this is clearly bad news with Friday a bruising day ... This story has echoes of the sub-prime fund suspensions that hit Bear Stearns and BNP in June and August 2007 respectively. We should note though that it took over a year for the Lehman default to come through (September 2008) and for the U.S. economy to enter recession. We would also say that the cash high yield market is a different beast to the complicated and highly levered structured credit products that destroyed markets and helped contribute to the GFC. Nevertheless similar timings to the Bear Stearns/BNP story would fit in with our long-term view that 2017 could likely be the next big problem year for financial markets and the global economy. This view is further fleshed out in our 2016 Outlook this morning which is called 'Late Cycle... But How Late?' Clearly the risks are that the credit market drags us there sooner. Indeed in the note we go through different variables showing that the U.S. looks late cycle from a macro and micro basis. However many of these suggest we're late cycle rather than at the end and what keeps us optimistic on Europe is that it looks well behind the U.S. credit cycle for now and with fairly attractive valuations ... In addition given that credit market liquidity is likely to cause huge problems when the credit and economic cycle both end we would have sympathy for those prepared to forgo a positive 2016 in order to reduce positions that are going to be more difficult to unwind quickly ahead of more difficult times. So dilemmas when you're at late cycle in an illiquid asset class."
Morgan Stanley's Adam Richmond & Co.
The combination of significant growth in credit markets, increasing susceptibility to retail flows, and shrinking dealer balance sheets has created a problematic liquidity backdrop. This did not matter much when volatility was low and the Fed was easing aggressively. Liquidity is not a problem until you need it in a big way. A Fed hike around the corner, oil rolling over, and market swings intensifying have exposed the vulnerabilities around liquidity in credit markets ... More important than the situation with this one fund, the longer markets remain dislocated the more the risk grows that this is the tightening in credit conditions that drives a cycle turn, a key reason why we moderated out constructive high-yield call in our 2016 outlook. However, in our view, the current situation is very different from the Great Financial Crisis, when the system had multiple layers of leverage, all of which were linked to the banking system in ways that were neither completely known nor understood. This is much less the case today.
Definitely one to watch.