FLASH UPDATE: Potential Systemic Risk from Bond Mutual Fund Redemptions

For nearly a year, we have been pointing out to investors the technical risk in the corporate high yield market stemming from the post-2008 role-change of dealers and prop-desks.  With the threat of and later implementation of the Volcker Rule and Dodd-Frank (Wall Street Reform and Consumer Protection) Act, dealers and prop-desks have either gone away or have drastically  changed the way they conduct business.  Of particular interest is the major shift from risk takers to being pure intermediaries, or match-makers.  In 2006 through the 3rd quarter of 2008, when high yield bonds started to fall, the dealer and prop-desk community provided some support to the market by having the ability to take on risk.  Since then, bank inventory of bonds has fallen 75% from its peak.  Throughout the development of our short high yield thesis, we have viewed this as a technical consideration that would likely act as a kicker to the trade.

Another technical consideration that we have considered, is the post-2008 proliferation of ETFs and mutual funds.  As growth in these products has exploded, investors have concurrently been forced to indiscriminately buy "yieldy" product, regardless of credit quality.  The government has essentially forced investors into buying these products, by systematically and artificially maintaining interest rates at historically low levels.  So, when assessing the high yield market at the half-way mark in 2014 we can easily observe that yields are at historic lows, spreads are at historic tights, prices are at historic highs, credit quality is tenuous at best and demand is obscenely high.  CCC-issuance and Cov-Lite issuance has supported our point that every company had access to capital markets after the crisis, and while demand has been extraordinary, we do not think it can last forever.  

The government via Fed Reserve officials, the same government that has unnaturally supported the high yield market, is now discussing whether regulators should impose exit fees on bond funds to avert a potential race for the exits, underlying the concern for the $10+ Trillion corporate bond market.  Retail investors have pumped more than $1 Trillion into bond funds since early 2009.  One of the main concerns is that these same investors can redeem from these ETF's and mutual funds at the click of a button, but the underlying credits can become less liquid in crisis scenarios.  Well known ex-Fed Governor Jeremy Stein said recently, "It may be the essence of shadow banking is...giving people a liquid claim on illiquid assets."  As retail investors typically are the last to get out in a crisis, they will take pain while exacerbating any high yield bond losses by exiting mutual funds and ETF's in mass, creating huge outflows that neither the government nor dealers / prop-desks will be able to contain.  

Introducing exit fees onto these types of funds would require a rule change by the SEC, which assuredly would be accompanied by resistance from some commissioners and likely protests from most retail investors.  This is purely conversation for now, but there is clearly concern from the top.  Significant risk has been shifted from banks to mutual funds, and with mutual funds generally being low leverage, systemic risk may be less than before the crisis, but before the crisis we did not have the sheer size of the ETF and mutual fund market that we have today.  I'm interested to see how it plays out, but we will certainly be on the right side of the trade.  

Enjoy the rest of your weekend,

Richard Travia

Director of Research

FLASH UPDATE: The Top 10 Catalysts for a Spike in the High Yield Default Rate

The Top 10 Catalysts for a Spike in the High Yield Default Rate

#10) Subprime Auto Loans & Student Loans – The resurgence of subprime auto loans with incredibly loose underwriting standards is a growing concern.  The $1.08 Trillion student loan balance, of which 11.5% is already 90+ days delinquent or in default, is already a problem.  The consumer is fragile and levered…if they can’t pay their car payment and student-loan bills, I’d be mighty concerned about top & bottom lines growing at consumer-driven companies. 

#9) Managing the De-leveraging Process Will Be Challenging – We are now 5+ years into a near zero interest rate, manipulated, Fed-driven environment.  The “Taper” has commenced and I think there will almost certainly be unintended consequences and fallout.  It will be an interesting movie to watch, one in which Chairwoman Yellen has no precedent or historical data with which to help predict future results. 

#8) Retail Support Can Go Away Fast – After 95 consecutive weekly inflows, leveraged loan funds reported outflows in April’s final two weeks.  Although full year 2013 High Yield mutual fund outflows totaled -$4.7 B, inflows since the 2^nd half of 2013 have been more than $13 B.  Our government forced retail investors to reach for yield by manipulating interest rates lower.  They own bond ETFs and Mutual Funds irrespective of credit quality.  Once it is probably too late, retail investors may sell in droves.  With ETFs & Mutual Funds making up such a large portion of credit investments, this could exacerbate and accelerate a race for the exits. 

#7) New Issue Exuberance Can End – 2010, 2011, 2012 & 2013 saw record HY issuance, at levels multiples higher than the years before the 2008 crisis.  April & May 2014 will end up being record HY issuance months.    Bankruptcy waves tend to follow times of indiscriminately large high yield issuance, as most recently seen with the “Tech Bubble” and the “Housing Bubble”.  Let’s see how the current “Liquidity Bubble” plays out. 

#6) Leverage is Rising – Many advanced economies are struggling with high debt and excessive leverage.  US Household Debt as a % of GDP is 81%.  Margin Debt, a leverage indicator which is the aggregate dollar value of securities purchased on margin, is at record levels.  People are stretching, and when they stretch they become vulnerable, very similar to many of the highly levered, vulnerable companies that we think will not be able to survive. 

#5) The European “Recovery” Could Have a Misstep – Spain, Russia/Ukraine, UK Household Debt to GDP of over 200%, corporate default rates already rising and other sovereign debt crises already brewing could absolutely trigger an interruption in Europe’s “recovery”.  Potential escalation of geopolitical risks, possibility of protracted weak growth in the euro area and further bouts of financial volatility along the path of monetary policy normalization are all significant risks that cannot be ignored.  If Europe has a problem, fear could quickly spread to the US as it did in the Summer of 2011. 

#4) A US GDP Hiccup Could Severely Impact Some HY Companies – GDP fell at a -1% annualized rate in the last quarter, the first contraction since 2011.  This was worse than most economists’ predictions.  Q2 GDP median projections currently are calling for a 3.5% expansion, which by the way would put us well below the average in the current recovery (as measured since mid-2009).  There are inordinate numbers of companies that are incredibly sensitive (indirectly) to GDP growth.  Most have survived in this tepid growth environment.  If things get much worse though, there could be pain taken. 

#3) Fundamentals Could Take Over – In the current fully-heated credit environment, there is very little differentiation between good and bad companies.  Some prices of high yield bonds have risen to levels that make no sense, especially when considering the fundamentals of the underlying companies.  Liquidity is currently abundant, but once the low credit standards that have driven issuance over the last five years becomes apparent, liquidity could dry up and the impact of the lack of dealer participation in HY bonds will be seen.  If this happens, you had better not be long. 

#2) The 10Y Treasury Yield Could Rise Precipitously – Levels of forward interest rates are incredibly difficult to predict, but if the love affair with US Treasuries ends, the word contagion as we know it will gain new meaning.  Remember “The Day the Dollar Died” (https://www.youtube.com/watch?v=2N8gJSMoOJc)?  HY companies will have difficulty borrowing new money and repaying their current debts.  Once this happens, default rates will likely spike. 

And…

#1) History Repeats Itself – The absurd levels of CCC issuance over the last several years may be a leading indicator to a spike in HY defaults.  45% of CCC’s default 4 years after issuance, 47% - 5 years after issuance, 53% - 6 years after issuance…This is based on the last 42 years of data.  On average, CCC issuance over the last 4 ¼ years has been more than 16% of total HY issuance.  The US HY bond market has grown by more than 40% since 2006 and we think that there are many catalysts to trigger a spike in defaults over the next several years.

Don’t wait for default rates to spike before taking an offensive position in shorting HY bonds.  The default rate in 2007 and 2008 was below 2% every month, with the exception of December 2008.  We had already seen extraordinary returns from being short before the spike.  Many institutional investors have started to make the move; we invite you to advance the conversations we’ve been having.  

Richard Travia

Director of Research