There is a reason why the Focused Credit Fund, a mutual fund that specialized in junk bonds, imploded on December 11 – the first fund to do so since the Financial Crisis. It experienced a run by its beaten-up investors and had to dump assets to cover the redemptions. This “forced selling” drove down prices even further. Finally, the fund blocked withdrawals. It would liquidate its assets gradually and pay the remaining investors the leftover subway tokens at some later time.
It was a classic liquidity mismatch, where a mutual fund held “illiquid” junk bonds, while investors were entitled to daily redemptions. This was exacerbated by the “first-mover” advantage in these kinds of open-end funds: the first investors out the door where made whole; those left behind ended up holding the bag [read… It Starts: Junk-Bond Fund Implodes, Investors Stuck].
The culprit? “Liquidity,” or rather the lack thereof, in junk bonds. The only way to sell junk bonds if you have to sell them is at much lower prices – at which there suddenly is liquidity. And why was there no liquidity at the higher prices? Because there was no “dumb bid.”
That’s the theory penned with impeccable timing ten days before this implosion by junk-bond guru Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors, in a commentary on S&P Capital IQ LCD, titled beautifully, “Can liquidity exist without a dumb bid?”
His answer is no. There are two divergent “camps” among junk-bond market observers, according to Fridson:
One group bemoans the loss of liquidity, which is causing bonds to fall more sharply on bad news than in the past. The other contends that little has been lost because the high-yield market actually never had genuine liquidity.
Liquidity in the junk bond market, now that selling pressures are rising, is in terrible shape. Actually, it has been in terrible shape since the Financial Crisis; only no one complained because low liquidity when buying pressures were strong caused bond prices to soar. The Fed, bond-fund managers, and investors loved that. Financial advisors loved it. Everyone loved it. But now the direction has changed, and suddenly they’re all scared.
A portfolio manager who turns negative on a name and decides to liquidate a large position must be resigned to disrupting the market more violently than would have been the case prior to the Global Financial Crisis. Commentators in the bemoaning-lost-liquidity camp attribute this change to reduced dealer inventories, in turn resulting from tightened banking regulations, imposition of the Volcker Rule, and the transparency created by the introduction of the TRACE system’s essentially real-time trade reporting.
Those who deny liquidity ever existed argue that dealers never really used their own capital to act as shock absorbers, even if they made more of a pretense than they now do of maintaining continuous markets. I come down more on the side of the latter than the former.
A point that repeatedly emerges from discussions of the current state of liquidity is the importance of the dumb bid (“dumb” is not used in this context in its literal sense of “mute” but in the slang sense of “stupid”). The only reason market-makers were sometimes able to make semi-respectable bids on deteriorating credits is that they had an outlet in the form of uninformed buyers.
This “dumb bid” that bids on anything without paying attention isn’t directly the retail investor but fund managers whose products, decorated with appealing and conservative sounding names, were sold to retail investors.
And that “dumb bid,” which is now sorely missing, disappeared during the Financial Crisis when, as Fridson put it, “calamitous trading losses have eliminated those dumping-ground investment organizations from the scene.”
While this elimination process has been going on for decades, “new dumb bidders” would crop up to replace some of those that collapsed. But the Financial Crisis was “a more thoroughgoing exterminator than past downturns, a sort of financial Black Death that wiped out nearly every dumb bidder.”
After the Financial Crisis, only those with “a well-honed understanding of corporate credit were left standing.” But they’re not willing to pick up damaged junk at inflated prices that a bond fund under duress has to sell.
Without this dumb bid, liquidity disappears until the price is low enough. Then liquidity reappears. This price may be very low for bonds that are heading for default, restructuring, or bankruptcy, as many of the junk bonds have already done this year.
And this is what happened to the Focused Credit Fund, which was created after the “dumb bidders” had been washed out:
Its assets under management soared from its inception in 2009 to over $1.2 billion by mid-2011. During the bond swoon triggered by the euro debt crisis, assets dropped and then flattened out at just under $1 billion. But when the Fed kicked off QE3, new money plowed into the fund, which more than tripled to about $3.5 billion by mid-2014. The fact that the fund, like other bond funds, was gobbling up junk bonds in an illiquid market pushed up prices to record levels. But then QE petered out while the price of oil began to collapse. As defaults and bankruptcies were appearing on the scene, investors started worrying about risks that they’d blissfully ignored before, and they yanked their money out.
What was sorely missing was the “dumb bid” that would have bought these damaged credits at inflated prices. It would have created “liquidity” and spread the losses to others. But without the dumb bid, the junk-bond market was declared illiquid, to the point that the SEC is now proposing new regulations for open-end funds – so that they don’t implode so quickly.
So where’s my free lunch? Read… I was asked: Whatever Happened to Inflation after all this Money-Printing?