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
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