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Junk Bond Contagion Spreading

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Junk Bond Contagion Spreading

contagionThe warnings were ignored by investors hungry for yield, and now there are too many panicked people trying to escape through a tiny door. It sounds like a zombie B-movie, but it's the reality of a junk bond market this week that has seen big funds stop redemptions, or fail altogether.

Investors large and small, who had forgotten the mantra that "high yield = high risk," (or thought they were smart enough to run before things got bad) have formed a panicked mob trying to flee to safety. The question is, "Who will get out alive?"

Bloomberg quotes Geraud Charpin, a portfolio manager at BlueBay Asset Management in London, which manages more than $60 billion, as saying “We’re in one of those moments where all of a sudden there’s a complete liquidity gap. If everybody wants to rush for the door it’s not going to happen and more funds may have to temporarily gate. You want to appeal to calm.”

Of course, telling everyone to remain calm usually has the opposite effect, especially where a loss of money is concerned.

And Then There Were Three

third avenue

The nightmare began last Wednesday night, when the junk bond fund Third Avenue Focused Credit Fund abruptly announced that it was freezing redemption requests and working to liquidate its holdings in an orderly manner. Once all assets are sold, proceeds will be forwarded to investors, who most likely will not receive all their money back.

A lot of the shock over the news was over the fact that Third Avenue is run by Martin Whitman, who pioneered the idea of exchange traded funds focused on junk bonds. Third Avenue is one of the most respected fund companies, and the Focused Credit Fund was once its top-performing fund.

The black eye that the freezing of redemptions and liquidation of the fund has given the company as a whole led to the weekend ouster of the firm's CEO.


As investors were still reeling from the news, another shock hit the market. Stone Lion Capital on Friday suddenly announced it was halting redemptions from its oldest fund. SLC was founded by two Bears Sterns veterans, and specializes in distressed debt and other high yield/high risk investments. The affected funds had $400 million under management.


The shell-shocked market woke up to news that a third fund had not only stopped redemptions, but that it had already liquidated its assets and shut down completely. Lucidus Capital Partners had specialized in credit default swaps. The failure of the $900 million fund is the latest and largest, with $900 million in assets. The CEO said that remaining funds will be disbursed to investors next month.

Panic In The Streets


Friday was the worst selloff for junk bonds since 2011, as panic swept the market. This is bringing to the forefront the pain of very tight liquidity in the junk bond and credit default swaps markets. Since the markets are now in full-on panic mode, there are nearly no buyers for people who are desperate to sell. This is the main reason Third Avenue and Stone Lion have suspended redemptions. They hope to get better prices later, than they'd get selling into a market rout. That day may not be soon in coming,

The Wall St Journal notes: Gaps as wide as 10% between the price bondholders are willing to accept and buyers are willing to pay are likely to be commonplace until at least the conclusion of the Federal Reserve’s two-day meeting Wednesday, hedge-fund and mutual-fund managers said.

fear of rate hike

The selloff on Monday was spreading to bonds that are rated more safe than junk status, pointing to the possibility that some investors were liquidating assets to meet margin calls on junk bond options. It may also be some people getting completely out of the bond market until they can see if the Fed raises interest rates, and what the fallout is. Billionaire investor Carl Ichan warned people that "the meltdown in High Yield is just beginning." Some market watchers note that a collapse in the junk bond market many times precedes a fall in stocks.

Analysts note that the run from junk bonds began earlier this year, as once high-flying funds began racking up large losses. The outflows accelerated as the odds of a Federal Reserve rate hike grew, until the market hit the tipping point last week.

Petroleum: Patient Zero


Following the chain of the snowball effect in junk bonds back to the beginning, we end up in the shale oil and tar sands fields. The fracking boom took off when oil was $110 a barrel. Exploration and drilling companies issued bonds with crazily low rates, compared to historical averages. Expecting a huge payday from their new wells, they saw nothing that would hinder their ability to either pay off or roll over the bonds they had issued.

Enter OPEC.

oil glut

A year ago, the oil cartel decided to try and drive their higher-cost competitors out of business. OPEC was losing market share to the shale drillers in the US, and saw an opportunity to drive them into bankruptcy before they could grow any larger. While the fracking industry proved far more resilient than OPEC expected, their plan is beginning to bear fruit.

Joining oil companies in the credit nightmare are mining and commodity companies. Liam Denning notes that the debt of just the "small fry" of junk bond issuers is greater than the entire value of some sectors.

Market analyst Bill Blaine says "We know energy names are in most trouble and that defaults are set to soar. At the moment it’s a false calm before the storm moment. There are no bids or offers. Nobody wants to be the first to jump."

Is the Nightmare on Wall St Just Beginning?

Bond fund managers have largely been on their own in the corporate bond market. The Big Banks and ratings agencies have been cutting staff. This leaves bond buyers without expert opinions on the viability of many corporate bonds. This comes at the same time that fund managers have the greatest exposure to corporate bonds since records began in 1997.

Credit Default Swaps (CDS) are financial instruments to insure against default. Risk premiums on junk bond credit default swaps are at the highest level in three years, signaling the rising risks of defaults.

Famous economist Mohamed el-Erian notes nine factors in the junk bond market that caused Third Avenue's fall.  He says that if investors can be convinced that it was the fault of the fund manager's investing strategy instead of the fault of the junk bond market in general, the fallout can be contained.


With the news that two more large junk bond funds have collapsed in the last two days, it may be time to duck and cover from that fallout.


The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.

About the Author

Everett Millman

Steven Cochran

Precious Metals Market Analyst
BS University of South Florida (2002)

A published writer, Steven's coverage of precious metals goes beyond the daily news to explain how ancillary factors affect the market.

Steven specializes in market analysis with an emphasis on stocks, corporate bonds, and government debt. He writes a monthly review of the precious metals markets for SurvivalBlog.com.

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