US junk bonds braced for bumpy 2016 as funds refuse redemptions

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Third Avenue, Stone Lion halt redemptions; net outflows for 2015 more than $10 billion.

by Ben Edwards and Louise Bowman

Weakness in commodity markets and expectations that the Federal Reserve would finally start raising interest rates for the first time in almost a decade had put US high-yield debt on course to rack up its first annual loss since 2008 in early December. By the second week in December, returns had sunk to -5.4%, according to Markit.

Lipper reported US high yield bond and loan outflows of $3.46 billion last week, the third worst week ever for the sector. The yield to worst on the BofA Merrill Lynch US HY index moved up to 8.75%, the highest yield the index has reached since October 2011 according to Twenty Four Asset Management. The US high-yield index returned -1.5% on Friday alone as news of growing fund distress emerged.

Outflows are starting to look ominous. Investors yanked $2.8 billion out of US high-yield mutual funds during the second week in December, the most since the first week in August 2014, according to Lipper. That took net outflows for the year to more than $10 billion.

Such are the nerves that outflows might rapidly accelerate that Third Avenue Management in December said it was shutting its credit fund and refusing redemption requests while the fund is wound down.

In a letter to investors, it implied that reduced liquidity in fixed-income markets meant it wouldn’t be able to meet anticipated withdrawals without risking selling bonds at a loss.

A second asset manager, Stone Lion Capital Partners, also halted redemptions over the weekend on a $400 million credit fund.

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Art DeGaetano,
Bramshill Investments

"Liquidity is one thing that you should be concerned about," says Art DeGaetano, chief investment officer at Bramshill Investments. However, John McGrath, head of distribution at Twenty Four Asset Management in London points out that the Third Avenue fund "was very specialised, very high beta indeed and had experienced losses of 27% year-to-date". It was more akin to a special situations and distressed debt fund than a traditional high yield fund.

The next 12 months could be even more challenging.

For instance, a further decline in commodity prices could spur wider contagion in the US high-yield market away from the energy sector as refinancing fears mount for lower-rated borrowers, UBS credit analyst Matthew Mish writes in a note.

Credit quality is also deteriorating, raising concerns among some investors that the current credit cycle is entering its final stages. Downgrades sharply outpaced upgrades in the first nine months of 2015, reversing the trend from the same period a year earlier, according to Standard & Poor’s. 

Defaults are expected to rise too. S&P is forecasting the default rate will jump to 3.3% from 2.5% in September. That could be at the conservative end of estimates: credit analysts at Royal Bank of Scotland expect it to rise to 4.6%.

JP Morgan expects US energy sector defaults to hit 10% in 2016, potentially rising to 20% in 2017. However, defaults for US high yield ex-energy are forecast at 3% for 2016, rising to 4.5% in 2017.

Meanwhile, uncertainty about the pace and path of Fed hiking continues to weigh on the market. Average junk bond yields had climbed to 8.1% by the second week in December from 6.3% at the start of the year, according to Markit. "Low levels of liquidity and fast money investors who may take their money out on the back of a Fed hike present a worrying backdrop for the market," says McGrath. "Investors considering these much higher yields on offer may have to be patient a little while longer before that technical position improves - although it is fair to say that big outflow weeks, like last week, do help to clear the tourists from the sector."

  Events outside the US might also impact the country’s high-yield market over the coming year.
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Brian Kloss,
Brandywine Global

Brian Kloss, head of high yield at Brandywine Global, says macro factors such as China’s economic prospects and further monetary easing in Europe are just as significant as any Fed movements.

And while defaults are expected to edge higher, the number of junk bonds trading at distressed levels is likely to be a more urgent problem for investors. Roughly a quarter of the US high-yield market is trading at distressed levels, according to UBS. Market participants reckon that number could swell in the year ahead.

"What we’re really concerned about is the distress ratios continuing to climb because that’s when you’re really going to lose your money," says Kloss. "You’re not going to lose it at the default, you’re going to lose it as the distress ratio climbs as the prices fall."

Yet despite these challenges, some money managers are optimistic.

Keith Bachman, head of US high-yield at Aberdeen Asset Management, reckons investors are being sufficiently compensated for the risks at current levels.