Have junk-bond investors flown too close to the sun?
Artist Ceasare d’Arpino. Source: British Museum
Icarus was the son of Daedalus, the master craftsman who built the Labyrinth for King Minos. In order to escape from Minos’s realm, he fashioned two pairs of wings out of wax and feathers for himself and his son, warning Icarus not to fly too close to the sun, nor too close to the sea—but to follow a middle path. Icarus couldn’t resist soaring high in the sky, however, and the sun’s heat melted his wings and he plunged into the sea.
The story is a warning about the twin faults of complacency and hubris, implying that hubris—reaching above our gifts and abilities—is the more attractive sin. But both are dangerous.
It appears that the bond market has a new example of hubris, in the closing of the Third Avenue Focused Credit Fund. This fund announced last week that they would be liquidating, but that it would take weeks or even months for investors to get their money.
This has roiled junk bonds, a $1.5 trillion market with about $600 billion held by mutual funds. Junk bond yields have risen to 9%, up from 6.5% just 6 months ago. Most of these bonds aren’t held by banks, though, nor are they held by consumers via mutual funds. So their losses are unlikely to affect bank lending or consumer spending.
But it’s dangerous to fly too close to the sun. Investors have been reaching for yield—trying to replace the income that would normally come from investment-grade bonds. They’ve used dividend-paying stocks, REITs, MLPs, and high-yield bond funds as substitutes. The Third Avenue fund was among the highest yielding of high-yield funds, investing in distressed credits near bankruptcy. A significant percentage of its holdings yielded more than 10%. At its peak, the fund topped $3 billion in assets under management. Last week, they had about $800 billion.
It’s always risky to fund illiquid assets with liquid liabilities. Investors are entitled to daily redemptions, while the fund’s assets don’t trade very frequently. This liquidity mismatch can plague small-cap funds, emerging market funds, even muni bond funds. Liquidity is not a constant thing. A screen price may reflect a slow market; when trading volume picks up, the price experiences a “jump condition” and moves to a new clearing level. Anything can face liquidity pressures, if no one is willing to place a bid for the security—any asset, any sector.
Just remember that just because a bond is illiquid doesn’t make it a bad credit. Liquidations and contagion like those facing the junk bond market create mispricing and opportunities, for those with strong stomachs and patient capital. And patience can be bitter—but its fruit is sweet.
Douglas R. Tengdin, CFA
Chief Investment Officer