Junk Bonds on the Naughty List

Brad-00447-cmykby Brad Houle, CFAExecutive Vice President

Last week, Third Avenue Management announced that they were freezing withdrawals from a leveraged credit fund. This announcement sent a wave of fear of broader contagion through the high-yield bond market. This fund bought bonds that were both illiquid and very risky from a credit quality perspective. Also, the fund employed leverage (borrowed money) in an attempt to enhance returns. This fund was swinging for the fences and not for risk adverse investors. This turbulence has bled over into the broader category of below investment grade bonds also referred to as high-yield.

Bonds that are below investment grade are often referred to as junk bonds due to the lower credit quality of the issuing companies. Junk bond is a somewhat of a pejorative description of an important part of the bond market. Small companies that are growing, a large engine for the U.S. economy, often fit into the category of below investment grade credit. It is important that there are public market debt financing options available for these entities. Because of the lower credit quality, investors demand more compensation in the form of interest in order to loan these companies money. Due to the lower credit quality there is a higher potential default risk for these bonds.

The genesis of this recent sell-off in the high-yield bond market has been the decline in the price of oil. Many smaller oil and gas companies use the high-yield debt market to finance their operations. When the price of oil declines these small oil and gas companies make less money and have more difficulty paying back the money they have borrowed. As a result, the prices on high-yield bonds in that segment of the market declined. Retail investors in mutual funds became nervous, withdrawing money from high-yield mutual funds and, to meet redemptions, the fund managers had to sell what they could to meet the investor demand for money. This dynamic has caused other parts of the high-yield bond market to decline as well.

Another wrinkle to this negative situation has been the decline in liquidity in the bond market. The Dodd-Frank Wall Street Reform and Consumer Protection Act that came from the financial crisis with the intention of reforming Wall Street has helped to create this predicament. Dodd-Frank severely limits the ability of large bank bond trading departments to inventory bonds, making building an effective market difficult due to capital requirements.

The higher quality investment grade market is where we invest our clients’ fixed income assets. Thus far, the investment grade bond market has only been modestly impacted by the sell-off. By comparison, the Barclays High Yield Index has declined 4.7 percent this year versus the Barclays Investment Grade Intermediate Credit Index which has returned 1 percent.

Our Takeaways from the Week

  • We don’t believe that the current disruption in the high-yield bond market will cause a broader contagion in the financial markets
  • We are particularly keeping a close eye on investment grade bonds where we have seen only a minor impact
  • This week the Federal Reserve hiked rates for the first time in nine years and we continue to expect a slow and gradual rise in the Fed funds rate and interest rates in general
  • We believe that this interest rate increase cycle will not end the bull market or push the economy into recession