US high yield sell-off: A long time coming

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The liquidity mismatch that has built up in sub-investment grade credit meant it was only a matter of time before the market blinked

The large technical sell-off in the US high-yield market at the end of 2015 was only surprising in that it didn’t happen sooner. The perfect storm of too much money chasing too few assets down the credit curve, together with a cratering oil price and jumpy retail funds, had been some time coming. It meant that the market ended the year in negative territory for only the third time in 20 years. 

Euromoney has written frequently about the liquidity mismatch that has built up in the subordinated corporate debt markets as mutual funds and ETFs have piled into high-yield bonds. The Third Avenue Focused Credit Fund that halted redemptions on December 9 had nearly half of its assets invested in bonds rated lower than single-B. Yet it was offering daily liquidity on what was essentially a distressed debt fund. 

That just doesn’t work. While the fund was an outlier in terms of the large percentage of sub-single-B debt it held, its fate could be the canary in the coal mine for high yield. It was down 27% on the year by the time it was shuttered and had suffered $1 billion redemptions throughout 2015, shrinking from $3.5 billion in July 2014 to $788 million.

It isn’t just high yield bonds that are frightening retail investors. After retail inflows of $81 billion between 2012 and early 2014, the US leveraged loan market had seen $47 billion exit again by mid-December 2015. You only have to look at the share price performance of a regular high-yield borrower such as Altice (€10.83 on December 15, down from €33.16 on June 26) to determine broader market sentiment about some of the lending activity that has been possible in a sub-investment grade corporate debt market awash with too much cash.

There are genuine reasons for concern in US high yield. Third Avenue’s is the largest mutual fund collapse since the Reserve Primary Fund broke the buck on September 16, 2008 following the collapse of Lehman Brothers. We are still living with the fallout from that event seven years later.

Such was the disquiet after Third Avenue’s move that some observers even called for the Fed to postpone its long-expected rate hike on December 16. Jeff Gundlach, founder of $80 billion asset manager Doubleline Capital, warned on December 8: "If the Fed hikes it will be a different world; everyone will have to unwind at the same time. If you think junk bonds are bad now, just wait."

Hike the Fed did, however, and the high yield credit markets seemed to cope initially. The extent to which they continue to do so will become clear in the early months of 2016.