On the surface, the surprise ousting of Third Avenue Management’s longtime CEO and the closure of its popular credit fund seems like a simple story of a fund gone bad. Between July and November, the well-regarded New York firm started by legendary value investor Marty Whitman saw more than US$1 billion leave its Focused Credit Fund, which owned distressed corporate debt. By mid-December, so many people wanted out that it blocked clients from removing their money, something that’s rarely done. Reports are now surfacing of alleged internal strife and bad decision-making.
Factors unique to the company may have contributed to the fund’s rapid decline. But there’s more going on here than poor planning and backroom arguments—something that is making even wary investors outside the corporate bond market sit up and take notice. One of the reasons Third Avenue’s credit fund folded was it couldn’t move its high-yield holdings—there just weren’t enough buyers for what the company was selling. It’s an issue experts on both sides of the border—including at the Bank of Canada—have been warning investors about for a few months now: There’s an alarming lack of liquidity in the credit market. “There’s a real concern here,” says Beth Hamilton-Keen, chairwoman of the CFA Institute’s board of governors.
According to an August PricewaterhouseCoopers report, trading volumes in European corporates declined by 45% between 2010 and 2015. While the corresponding volumes have risen in the U.S., the turnover ratio—the number of bonds sold and replaced in a fund—has dropped by about 40% since 2005.
The lack of liquidity has a lot to do with regulations imposed on banks since the 2008 financial crisis, says Hamilton-Keen. In the past, banks would happily buy corporate bonds that investors wanted to dump and then either sell them to someone else or package them up in another type of security. This buying and reselling of debt is partly what got the banks into trouble during the recession, which is one reason regulators now force financial institutions to keep more capital on their balance sheets.
However, that means they have less money to spend on corporate bonds. In 2006, U.S.-based security brokers and dealers owned about US$400 billion in corporate and foreign bonds, according to the Federal Reserve Board. Now that number is around US$100 billion, which is near 2000 levels. “Banks were able to use their balance sheets to provide liquidity to the market,” says Hamilton-Keen. “The rules changed, but we hadn’t seen a full assessment of the impact. It appears now that it’s reduced the willingness to provide that liquidity.”
Adding to the problem is the fact that over the past few years, some of the most sought-after corporates were in the energy sector, says Dhruv Mallick, a fixed-income analyst with Vancouver’s Leith Wheeler Investment Counsel. As oil prices have fallen, defaults in the sector have risen—about a quarter of all corporate bond defaults in 2015 were energy related, according to Moody’s—and that’s made traders even more reluctant to buy.
From a purely buying-and-selling perspective, the liquidity issue is only a difficulty for those invested in high-yield funds. But the more people who get wind of the fact that there’s a concern with credit, the higher the likelihood that other markets will react negatively. Investing tends to be driven by sentiment, and fears of a credit crunch could spill over into the equity market, says Alfred Lee, a fixed-income portfolio manager with BMO Asset Management.
While Lee thinks the credit concerns are overblown—he notes that new trading technology has made it easier to sell to buyers who wouldn’t have had the chance to purchase before—if we see more funds close, more fixed-income defaults and a heightened sense of panic, things could turn for the worse. “If you have concerns stemming from the macro environment and that causes risk to come out of the bond market, then that may spill over to the equity markets,” he says.
We’ve seen this happen before, most recently in 2008. Historically, credit markets dry up first in a financial crisis, and equity markets follow. So far, though, no one is reporting any unusual outflows in the bond market, but Hamilton-Keen cautions investors against chasing high-yield products. Many people have bought into this space because it’s one of the only places to get decent yield, but she points out that a number of companies only offer corporate debt because of market demand.
Those who do want to add corporate bonds to their portfolio should think of this fixed-income market the same way they do stocks: Defensive companies are the best bet in turbulent times. Mallick thinks there’s still good value in telecom and health-care bonds, both of which have sold off in recent months. “They don’t have exposure to commodity prices, but you can get a similar return on the upside,” he says, adding that it’s much easier to find buyers for defensive names.
Hamilton-Keen advises investors to stick to investment-grade corporates. They also need to be realistic about returns; even a 7% return may be too good to be true these days, she says. As well, make sure the company you invest with can withstand any sudden redemptions.
Most important, remember not to panic yourself. If energy prices stay low for much longer, there could be more defaults, and that will amp up the anxiety. Non-commodity bonds are mostly doing well, however. Stick to bonds—and stocks—in defensive sectors, and hang tight. “The big questions will be: Does it spread into other sectors, and will we see more contagion?” says Mallick. “We aren’t yet seeing evidence of that, and the U.S. is not in a recession, so I think this is temporary.”
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