It Starts: Junk-Bond Fund Implodes, Investors Stuck

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And the next crisis hasn’t even begun yet.

We have warned about “open-end” bond mutual funds, particularly those with a lot of high-yield bonds. We know some folks who got burned when Charles Schwab’s $13-billion bond fund SWYSX blew up during the financial crisis and lost 60% or so of its value before its data went offline.

Schwab settled all kinds of class-action and individual lawsuits for cents on the dollar. It got in trouble over other bond funds. And other purveyors of bond funds got in trouble too.

It works like this: When an “open-end” bond fund starts losing money, investors begin to sell it. Fund managers first use all available cash to pay investors. When the cash is gone, they sell the most liquid securities that haven’t lost much money yet, such as Treasuries. When they’re gone, they sell the most liquid corporate paper. As they go down the line, they sell bonds that have already lost a lot of value. By now the smart money is betting against the fund, having figured out what’s happening. They’re shorting the very bonds these folks are trying to sell.

The longer this goes on, the more money investors lose and the more spooked they get. It turns into a run. And people who still have that fund in their retirement account are getting cleaned out.

Bond funds can be treacherous – especially if they hold dubious paper, which is never dubious until it suddenly is. And when they get in trouble, you want to be among the first out the door. Here’s one of our more recent warnings on open-end bond funds, May 20 this year: Are These Ticking Time Bombs In Your Portfolio?

The $1.8-trillion or so of US junk bonds are everywhere. Investors loved them because they have discernible yields in the Fed-designed zero-interest-rate environment. Junk bonds were hot, and so were the funds. People went for them, with no idea that they were putting their nest egg in a fund larded with explosives.

A significant part of Corporate America is junk rated, well-known names like Chrysler, Valeant Pharmaceuticals, or iHart Communications, yup, the LBO wunderkind owned by private equity firms and weighed down by $8.9 billion in debt that is now “distressed.”

They issue debt because they’re cash-flow negative and need new money, or because they gorge on M&A, or have to fund share-buybacks and special billion-dollar dividends back to the private equity firms that own them. During the boom years of the credit bubble, nothing could go wrong. And now, as ever more junk bonds wither, crash, default, and cause their owners to tear out their hair – just then, a bond fund implodes.

And the next crisis hasn’t even started yet.



Even we, cynical as we are about the credit bubble, its demise, and what it means for bonds and bond funds, didn’t expect it to happen this soon. This is how the Wall Street Journal introduced the topic:

A firm founded by legendary vulture investor Martin Whitman is barring investor withdrawals while it liquidates its high-yield bond fund, an unusual move that highlights the severity of the monthslong junk-bond plunge that has swept Wall Street.

The fund is Focused Credit Fund by Third Avenue, which manages other funds and has $8 billion in assets under management. Earlier this year, the fund had about $2.5 billion in assets. Then its asset values plunged – the fund is down 27% this year – and redemptions hit, whittling it down to $788 million.

It wasn’t the only high-yield bond fund to lose money this year – the 30 largest ones tracked by Morningstar have lost money – but it’s one of the worst.

To stop the forced selling in an illiquid market, while hedge funds had figured out what was going on and were shorting the bonds and driving down prices even further, and to put all the remaining investors into the same boat, the company decided to stop filling sell orders.

The Wall Street Journal:

The firm took the unprecedented step, notifying the SEC just hours before publicly announcing the transaction, because it needed to act quickly to preserve its remaining assets, said Third Avenue Chief Executive David Barse.

Obtaining “relief from the SEC is a time-consuming process, and time was not on our side,” he said.

So they’ll lock up everyone’s money for the time being, what’s left of it, put the remaining assets into a liquidating trust, and sell them off gradually, rather than at fire-sale prices, and eventually liquidate the fund.

Investors will get some of their money back on December 16. The liquidation process may take more than a year. Investors better be ready for a long wait. Even then, they’ll eat big losses. That’s the rosy scenario. It assumes junk bonds don’t go downhill from here.

But those first out the door were made whole. That’s how open-end bond funds work when things turn sour. On the other hand, investors who own bonds outright can hold them to maturity. They lose money only if the bond defaults.

What’s next? The Wall Street Journal:

Now, investors are focused on whether other funds may run into similar investor withdrawals and problems as the year-end approaches. Many investors move to exit losing funds and investments late in the year to generate losses to reduce capital gains taxes, traders said.

Then there’s the lesson that might motivate investors: first out the door wins. They’re already heading for the door.

$3.5 billion in retail cash fled US junk-bond funds during the week ended December 9, S&P Capital IQ LDC reported on Thursday: $2.8 billion of mutual-fund outflows and $637 million of ETF outflows. It was the second largest one-week redemption ever, behind the record $7.1 billion outflow during the week ended August 6, 2014.

“We are looking at real carnage in the junk bond market,” bond guru Jeffrey Gundlach announced in a webcast on Tuesday, as the high-yield market takes on ominous tones and threatens not only the broader economy but also stocks. Read… Bond King Gets Antsy as Junk Bonds, Which Lead Stocks, Spiral to Heck




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  26 comments for “It Starts: Junk-Bond Fund Implodes, Investors Stuck

  1. VegasBob
    December 11, 2015 at 2:52 am

    Wolf,

    Thanks for clearly explaining precisely why one should never invest in bond funds.

    I’m a bond investor, but I only hold individual bonds, so I only take the hit if and when a bond defaults, as you so clearly explained.

    I hope all of your readers who are invested in bond funds or are tempted to buy bond funds read and re-read this article until they understand it.

    Bond funds got killed during the last crisis in 2008-2009, and that was when interest rates were still relatively high. I think the carnage in bond funds is going to be much much worse this next go round, due to the Fed’s interest rate suppression. My guess is that bond funds that were down only 10-20% last time will be down 30-60% or more in the next crisis, and the junk bond funds will fare even worse.

    • Vespa P200E
      December 11, 2015 at 11:00 am

      Bondholders can also get screwed by whims of government and unions…

      I owned GM Series B and C bonds with juicy yield then came 2008 meltdown and GM became Government Motors with US taking over its finances under BK and bond holders got the raw deal with US government and UAW ahead of the old bondholders with UAW thugs got the swestest deal and equity since it was really Obozo bailing out GM to save its staunch Dem voting machine. And yeah US taxpayers lost billions along with the bond and distant equity holders.

      At the end I got some newly issues Government Motors shares which was not easy to sell since not whole # of shares were issued.

      This ain’t no capitalism but nanny socialism the commies would pull…

      • walter map
        December 11, 2015 at 3:35 pm

        You had plenty of opportunity to bail before the bubble burst. Why didn’t you? It’s not as if you weren’t warned, and repeatedly. And you surely weren’t reassured by those who were running the scams. Were you?

        The real culprit was and is, of course, the management of GM, and not the government and certainly not the UAW, probably the greatest victim. If GM had not been bailed out you would have gotten nothing, so show some appreciation.

        Remember that GM makes vehicles as a side project because it’s main business is finance, where the real money is, and one must be particularly wary when speculating on the issuances of financiers, for you be crunchy and taste good with ketchup.

  2. Vespa P200E
    December 11, 2015 at 10:52 am

    Heck they call it JUNK bond for a reason…

    It started with savvy and rather weak-handed funds liquidating knowing tsunami of redemptions is forthcoming so better get out of dodge while they can thru the getting crowded exit door.

    Next up are margin calls to the investors small and big alike foolishly over-leveraged/margin to hilt coaxed in by higher interest rate in ZIPR environment not having read/understood the prospectus about losing their shirts. Leverage is awesome when the market goes up and a real bxtch when it tanks…

  3. VegasBob
    December 11, 2015 at 12:22 pm

    Wolf,

    Your crystal ball is amazing. You published this article Thursday night and the junk ETFs (HYG, JNK) are melting down today (Friday).

    Where can I get a crystal ball as accurate as yours?

    • December 11, 2015 at 5:42 pm

      Thanks, VegasBob. But hey, timing was luck. I wish I had a crystal ball that would let me nail in advance the day of a big sell-off.

      What has been visible though, and what I have written about for months, is the deterioration in the junk bond market. Combine that with the structural unsoundness of open-end junk-bond funds, and sooner or later you’re going to get a blowup.

    • Spencer
      December 11, 2015 at 7:20 pm

      …and Dave Kranzler December 9/15…Wednesday…

      http://investmentresearchdynamics.com/the-credit-markets-are-starting-to-collapse/

      Roll the credits Bugs.

      Thank you both though. Much appreciated.

  4. AC
    December 11, 2015 at 1:19 pm

    It is worth remembering why people are desperate for yield, so desperate they were buying garbage with a high (hypothetical) return.

  5. Boatwright
    December 11, 2015 at 1:30 pm

    To quote John Kay:

    “More than a half-century ago, John Kenneth Galbraith presented a definitive depiction of the Wall Street Crash of 1929 in a slim, elegantly written volume. Embezzlement, Galbraith observed, has the property that “weeks, months, or years elapse between the commission of the crime and its discovery. This is the period, incidentally, when the embezzler has his gain and the man who has been embezzled feels no loss. There is a net increase in psychic wealth.” Galbraith described that increase in wealth as “the bezzle.”

    In a delightful essay, Warren Buffett’s business partner, Charlie Munger, pointed out that the concept can be extended much more widely. This psychic wealth can be created without illegality: mistake or self-delusion is enough. Munger coined the term “febezzle,” or “functionally equivalent bezzle,” to describe the wealth that exists in the interval between the creation and the destruction of the illusion.

    Read more at https://www.project-syndicate.org/commentary/asset-bubbles-price-boom-by-john-kay-1-2015-10#yit5xQpKR4xKDZLl.99

    • BradK
      December 11, 2015 at 9:14 pm

      Thanks for that, Boatwright. My favorite paragraph was the second-to-last:

      The essential story of the period from 2003 through 2007 is that banks announced large profits and paid a substantial share of them to their traders and senior employees. Then they discovered that it had all been a mistake, more or less wiped out their shareholders, and used taxpayer money to trade their way through to new levels of reported profit.

      As succinct as it is tragic.

  6. Mark
    December 11, 2015 at 1:58 pm

    Never invested hard earning cash in bonds and never will.
    Love stocks and real estate.
    Right now I’m all in cash, seating duck waiting for storm to settle down
    ( even though I think this might take some time).

  7. Petunia
    December 11, 2015 at 2:03 pm

    Most of the borrowed money in corporate America is misspent in one way or another. Almost none of it is used in any productive capacity. Why is anybody investing in bonds, when the payments come from more borrowing. Just asking?

    • MD
      December 11, 2015 at 8:13 pm

      To expand on your point – US total debt (public + private) is around $60 trillion, up about 50% from $40T in the mid-2000’s.

      But, the US is increasingly a service economy, we’re told. 85% of the GDP is service-based. Everyone is a lawyer, consultant, banker, software engineer, restaurant worker, etc.

      But those jobs aren’t capital intensive. So why do we need so much extra debt? What big projects are companies and governments investing in?

      Answer: none. We’re pulling forward demand from the future. If this increase in debt was used to fuel projects with terrible ROI – energy projects that go bust, housing projects that go bust, welfare benefits, etc – then we’re going to pay in the future with nasty deflation.

      • @z
        December 12, 2015 at 12:30 pm

        Quantitative Easing accounts for trillions of debt held by the Fed. Entitlement spending beyond tax receipts accounts for a of government borrowing. However junk bonds in the portfolio of Calpers and other pension plans are loans to questionable private sector borrowers. I want to talk to another contrarian who sees opportunity in the imminent stampede to the exits.

  8. chris Hauser
    December 11, 2015 at 2:04 pm

    um, sometimes i read bond fund prospectuses or reports and marvel at the numbers of bonds out there. things i’ve never heard of, or have no idea what they are.

    marvel, i do.

    prefer not to invest in buckets.

  9. B.S.
    December 11, 2015 at 3:13 pm

    The word is getting out pretty good:

    http://www.bloomberg.com/news/articles/2015-12-11/junk-bond-fear-gauge-nears-3-year-high-after-third-avenue-freeze

    http://www.marketwatch.com/story/why-the-junk-bond-selloff-is-getting-very-scary-2015-12-11?dist=countdown

    DJ Junk-Bond Selloff Intensifies After Fund’s Demise — Update
    12/11/15 15:08:00

    By Mike Cherney, Matt Wirz and Leslie Josephs
    The selloff sweeping the U.S. junk-bond market intensified Friday as investors fretted over the fallout from the abrupt closing of a high-profile bond fund.
    Two exchange-traded funds that closely track the low-rated corporate bonds registered large losses on Friday. The iShares iBoxx $ High Yield Corporate Bond ETF and the SPDR Barclays High Yield Bond ETF were both down about 2.6% early Friday afternoon. The iShares fund was on track to close at the lowest level since at July 2009.
    The declines fueled a broad pullback from riskier assets, as investors braced for the Federal Reserve to raise U.S. interest rates next week for the first time since 2006. The Dow Jones Industrial Average dropped 273 points, or 1.6%, to 17,302 Friday. The S&P 500 shed 1.6%, dragged down by a 2.8% decline in the energy sector, putting it on track to fall 3.5% this week, its biggest weekly decline since mid-November.
    The iShares ETF was trading at a discount to the value of the fund’s underlying holdings, an unusual event that points to market stress, said an ETF trader. Exchange-traded funds hold portfolios of assets, like mutual funds, but are listed on exchanges and trade intraday.
    He said the trading shows that investors are hesitant to buy ETFs, fearing they won’t reliably be able to sell them without accepting large discounts–a concern that has loomed over markets since ETFs became popular over the past decade. The concerns apply to many sorts of the funds but are most intense in bond funds, because the underlying bonds often don’t trade with regularity, raising questions as to whether fund prices accurately reflect market conditions.
    The iShares junk fund, commonly known by its ticker symbol HYG, generally trades at a premium to the value of its underlying holdings. In the first nine months of the year, HYG was at a premium to its underlying holdings for 150 days, and at a discount for 35, according to the fund’s page on iShares website.
    Average daily trade volume is about 3,468,300 shares. Friday’s was 40,880,000 as of mid-afternoon.
    Some energy-related exchange-traded products slumped Friday along with the price of oil. The Direxion Daily Natural Gas Related Bull 3x ETF, a leveraged fund that provides outsize exposure to the natural-gas market, was the biggest decliner–shedding 16.5%
    Of the 20 biggest decliners among exchange-traded products of the session, 11 were tied to energy prices or companies in that sector.
    The popular $6.7 billion Alerian MLP ETF was down 6.7% at $10.31, outpacing losses in the S&P 500 and the S&P’s index of energy companies, which is down 2.9%
    Even ETFs tied to industries that can benefit from cheap energy prices–cars and airlines–were down sharply, a symptom of the broad-based selling on Friday. The US Global Jets ETF was own 3%, while the First Trust Nasdaq Global Auto Index Fund was down 2%.
    “I think the bonds are playing catchup to where the ETFs trade,” the trader said. “I think you’ll continue to see bond prices fall.”
    Investors piled into U.S. government bonds to preserve capital Friday, pushing down the yield on the benchmark 10-year Treasury note to 2.141% from 2.239% Thursday. Bond prices rise as their yields fall.
    The yield on the two-year note also fell to 0.899% from 0.947%. The yield, highly sensitive to expected changes in the Fed’s rate policy, remains near a five-year high set earlier this month.
    The renewed carnage comes after Third Avenue Management LLC decided to bar investor withdrawals while it liquidates the $789 million Third Avenue Focused Credit Fund, meaning that current investors may not get their money back for months. The decision was made public this week.
    Many individual junk bonds were also in the red Friday, affecting a broad swath of industries including telecommunications, media, energy and health care. Oasis Petroleum Inc.’s bond due 2022 was one of the most actively traded junk bonds, with $63 million changing hands as selling pushed its price down 3% to 76 cents on the dollar, according to data MarketAxess Holdings Inc.
    Exemplifying the breadth of industries affected, a bond from telecommunications firm Sprint Corp. traded Friday at 67 cents on the dollar, down 2.3 cents on the day and down from nearly 95 cents earlier in the year.
    Junk bonds have been roiled in recent weeks by the prolonged slump in commodity prices, sparking concerns that many U.S. energy producers–a large chunk of the junk-bond market–would be unable to pay back their debt. But the negative sentiment has spread to other parts of the junk market, dragging down prices on other companies’ debt, investors say.
    Some have warned for months of dangers in the market, which has received tens of billions of dollars of fresh investor cash since the financial crisis. Investor Carl Icahn tweeted Friday that “unfortunately I believe the meltdown in High Yield is just beginning.”
    Some fund managers said they were concerned that headlines about Third Avenue’s fund could prompt individual investors to dump other bond funds, even if the funds are invested in much higher quality debt than what Third Avenue bought.
    The closure of the Third Avenue fund is “a worrisome situation and definitely could have spillover effects,” said Matthew Duch, who helps oversee the $130 million Calvert High Yield Bond Fund. “It’s a major thing to watch.”
    Write to Mike Cherney at mike.cherney@wsj.com, Matt Wirz at matthieu.wirz@wsj.com and Leslie Josephs at leslie.josephs@wsj.com

    (END) Dow Jones Newswires
    December 11, 2015 15:08 ET (20:08 GMT)
    Copyright (c) 2015 Dow Jones & Company, Inc.- – 03 08 PM EST 12-11-15

  10. KIllings
    December 11, 2015 at 7:03 pm

    Financialization is the process of creating attractive looking bubbles. It’s horrifically unethical and immoral for sure. But it’s not where the really outrageously grotesque Ponzi-styled crimes committed by our financial high-brows are found. The fact is that Corporate power’s ascendancy over politics and society – by now mostly financial – has reached the point that both political organizations, which at this stage barely resemble traditional parties, are far to the right of the population on the major issues under debate. And these financial parasites DID NOT ACCOMPLISH THIS UNDER ANY SEMBLANCE OF LEGALITY.

  11. Nick Kelly
    December 11, 2015 at 8:08 pm

    Well I’m going to say that I don’t think the Fed will raise Dec.16

    I may seem dumb but just too much has happened in last 48 hrs, including the above post.
    No one could accuse Yellen of doing anything drastic if she continues a policy 8 years old.
    But they sure will if a change coincides with a crash. Note: ‘coincide’ it may not cause a crash but will get blamed anyway if one happens.
    Add to this the openly expressed opinions of the IMF and, incredibly, of Ben Bernanke who warned against tightening BEFORE the latest carnage.

    But I wouldn’t give odds to a guy who wanted to bet against me.

    • Vespa P200E
      December 13, 2015 at 4:17 pm

      I agree with Fed should not raise the rate give the poor economy teetering back into the Great Recession II.

      BUT Janet having lost credibility already will FOREVER lose face as she signaled the 0.25% raise back in Sept only to not deliver declared rather strongly that she is gonna raise the rates in Dec.

      Alas, just 2 days before mother of all Triple Witching options unwind Fri – there goes Santa rally and more like Santa melt down leading to market getting unglued come Jan 2016.

  12. michael
    December 11, 2015 at 10:03 pm

    If the FED does not raise in it will be admission of their impotence. The result would be quite interesting.

  13. ML
    December 11, 2015 at 11:26 pm

    When investors lose money it is always someone else’s fault.

  14. Dave Mac
    December 12, 2015 at 9:45 am

    Will money from junk bonds now go into equities?

    • Boatwright
      December 12, 2015 at 10:08 am

      As is often said in such times: Cash is king………

    • economicminor
      December 12, 2015 at 3:51 pm

      Dave, as I understand this, the first out may have gotten their money out but many will be stranded. Many people will panic or be forced to sell at much lower values. This money just evaporates into thin air. It will just no longer exist as a positive balance sheet ledger entry. At first there may be a small buying in other markets but Just like ZIRP was positive, the big losses in bonds will be extremely negative.

      As pointed out in the piece above, once this starts it could go very fast as many of the companies are really Zombies and do not really produce any valuable products. Or have way more debt than can be serviced with existing revenues.. A little fear could destroy many of them.. AND if what appears on the surface in lower consumer demand is real and if the FED is actually dumb enough to raise interest rates on newly created ponzi money.. The down side could accelerate. And be quite deep.

      When both stocks and bonds sell for less than what was paid for them, there is a real loss in balance sheet dollars. The bond market is way bigger than the stock market and if both were to head down together, our economy will also crash..

      The result would be called Deflation. The entire stock of dollars (on balance sheets) could drop by $trillions in a few weeks or a month. The FED may try and stop it.. So might Congress again.. Whether they could is very questionable. I personally don’t think they could this time.

      Are we there yet? Probably not.. Maybe after the year is over and the Q1 results are printed.. And the reality of lower demand and lower revenues finally affects the bottom line.. But then there is always QE4, 5 or 6 and the FED’s attempt to reflate again..

  15. MC
    December 12, 2015 at 1:58 pm

    Junk bonds are like the shark swimming just below the surface with its fin just showing. You know the shark is there but what shark is it? A completely harmless Basking shark or something far more threatening?

    This is what even desperate-for-yield investors have started asking themselves. Defaults have already started: just this week not one but four junk-rated Italian banks defaulted on their obligations, wiping out thousands of savers in the process. The government promised “some relief” but already made clear it will be on a case by case basis and nobody will be made whole. The money is simply not there.

    The bottom has already fallen off CCC rated bonds, which now yield over 15% even in presence of NIRP’s and ZIRP’s. The shark is starting to show more of its fin and bathers nervously joke it does look like a Basking shark while people on the beach debate if it’s a Great White or a Mako.

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