Liquidity: Closing the Gate

Series: Liquidity

This series explores how market liquidity has been drying up in recent years, sowing the seeds for a much more violent rout when the next financial crisis arrives, how the investment community is quietly preparing for the eventuality and what you should do about it.

Concerned by the dearth of liquidity, the investment community is quietly engaged in disaster preparation. How should an individual investor prepare also for the eventuality?

Sensing the ripening opportunity for shorting in the illiquid high yield bond and ETF markets, the lead wolves amongst the hedge funds are preparing for the kill.

The flash crashes of some of the largest blue chip tracking ETFs on Aug 25 should serve as a warning of what’s to come for their smaller and illiquid high yield brethren.

Faced with mounting losses in their bond portfolios and massive redemption requests, mutual and hedge funds begin suspension of any and all redemption requests. The next phase of the junk bond crisis has begun.

This is an update to the continued unfolding saga of liquidity.

As a refresher, Part 1 of the liquidity series laid out the background which gave rise to this problem and the advent of Exchanged Trade Funds (ETFs) and other instruments which allow fund managers and retail investors to venture into the risky high yield bonds with little understanding of the underlying risks. Part 2 of the series described fund companies, growing increasingly worried about dearth of liquidity in their bond portfolios, are quietly raising cash in anticipation of redemption requests. Liquidity: Setting the Stage for the Hunt describes how the hedge funds, sensing the coming crisis for these risky bonds, are setting the stage to short these bonds and ‘kick them when they are down’. And lastly, in Liquidity: ETF Flash Crashes we bear witness to a taste of what is to come to a troubled bond market with practically no underlying liquidity when everybody and their mother want to get out.

Events seem to be hitting the ‘event horizon’ pretty much in textbook fashion. First the high yield bond market is starting to reacquaint itself with gravity. New investors are now getting cold feet after witnessing other earlier investors in the same space taken to the woodshed.

 

CCC high yield bond index
Triple C bond yields

Yields for the triple hooks, i.e. the junk of the junk bonds rated CCC or lower, which have been rising steadily in the course of 2015, went berserk in the past two months. The current yield above 17% is higher than what these bonds were trading at during the height of the Eurozone crisis in 2011, signalling something serious might have blown up behind the curtain or that there is a broad and sharp deterioration at this end of the risk spectrum, possibly both.

Remember when a broad market fails, it usually happens at the periphery (the risky end in this case) and migrates to the core.

Another significant milestone was reached this week, possibly signifying that the unravelling of the HY markets has entered the next phase.

After suffering a devastating 27% loss in YTD 2015 (remember this is supposed to be a ‘safe’ bond fund) and massive redemption requests, the Focused Credit Fund, a high yield bond fund with $2.4 billion AUM by Third Avenue which happened to be a top 1% performing fund in 2013, has entered a “Plan of Liquidation” effective immediately.

Worse yet and also effectively immediately, Third Avenue management has decided to suspend any and all redemption requests, because, in their official statement, “ Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”

One day later, Manhattan-based Stone Lion Capital, a hedge fund specializing in distress debt and other risky investments, pulled down the same gate on investors making redemption requests. Reason? The same – facing substantial redemption requests to the $400 million Stone Lion Portfolio LP, forcing the fund to sell into a market which is bone dry in terms of liquidity.

Hedge funds and other vultures in the financial ecosystem, as espoused in our previous musing Liquidity: Setting the Stage for the Hunt, have smelled the blood of the first victims and should now be out in force short selling these beaten bonds using such favourite tools as credit default swaps (CDS), driving the bonds further into distress. The wolf pack hunting down its prey as described in the article will unfold in perfect analogy as the hedgies drive panic into the investment crowds and pick off the single name bonds one by one. Very sad to watch but you do get a front-row seat.
Just to re-cap:

  • During the 2008 global financial crisis, the central banks embarked on an insane policy of bringing down interest rate to zero (ZIRP), ostensibly to stimulate the real economy, in order to save the private too-big-to-fail banks.
  • Starved for yields, mutual fund managers, pension fund managers and retail investors, gorged on risky high yield bonds to get some pitiful extra yields but blind to the risks they are taking in exchange for such extra yields. Investment banks, other underwriters, ‘analysts’ and promoters of such bonds reap good profits pushing these junks to unsuspecting investors.
  • Unsophisticated investors are unaware of the illiquid nature of these bonds. Mutual funds and ETFs further mask their illiquidity and create the impression that one can sell or redeem his ETF or mutual fund units into a liquid market and get his cash back at the end of the day.
  • The global economy is slowing deteriorating. The carnage in the high yield bonds issued by tight oil and shale gas companies is now spreading to other sectors of the economy.
  • Investors start to panic and withdraw money. Fund managers are forced to sell bonds into an illiquid market to fund the redemptions. The selling forces bond prices even lower – and more investor panic.
  • Facing a wave of redemption requests, a fund lowers the gate and refuses further redemptions.
  • You can check out any time you like, but you can never leave…… Hotel California.
  • Next likely events:
    • more mutual funds and hedge funds shutting off the gate for exiting investors.
    • The contagion will spread from the HY to the investment grade (IG) space. Remember, trouble usually starts at the periphery and spreads to the core.
    • The awakening and ensuing panic will likely spread to equities. Keep in mind that debt market investors are head and shoulders more sophisticated than stock market investors. Historically the bond markets serve reliably as the leading indicator for the equity market.

For those who did not heed the earlier warnings and got out of the crowded theatre before it catches fire, it might be too late. Many funds will follow suit and lower their gates in an act of self preservation. For those who have significant exposure to the financial markets, it bears repeating that at this juncture, you should be more concerned about the return OF your capital than the return ON your capital.

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