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The Third Avenue’s decision to liquidate raised fears of a junk bond crisis

Discussion in 'Fundamental Analysis' started by FXStreet_Team, Dec 24, 2015.

  1. FXStreet_Team

    FXStreet_Team Well-Known Member Trader

    Oct 7, 2015
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    FXStreet (Mumbai) - Given that interest were held at record low levels by the Federal Reserve for almost seven years it is hardly surprising to note that risk taking on Wall Street had increased manifold. Investors had all flocked to Wall Street looking for higher returns in their bond portfolios. The nominal dividend yield on these stocks exceeds that of the 10-year Treasury note. This feature increased the lucrativeness of the bond market for investors who were reeling under the impact of prolonged low interest rates. Yields are extremely high on junk bonds as they are among the riskiest bonds one could purchase. People are ready to take risk of default given the tempting reward.

    The news of the Third Avenue Focused Credit Fund announcing that it was liquidating was bound to raise hell raising fears of a crisis similar to the one caused by subprime mortgages in 2007-2008. Investors worry that the high yield debt market might collapse. Carl Icahn, who has created his at over $21 billion fortune using junk bonds described the junk bond market as a “keg of dynamite that sooner or later will blow up.” He has warned that a lack of liquidity would lead the junk bond market to implode and this will in turn contribute to a broad market crisis.

    What sparked the fear? The Third Avenue Focused Credit Fund announced it was liquidating and that it would block investors from taking money out of the fund. Traditionally, mutual funds do not behave in this manner. However, given that the Third Avenue suffered over $1.3 billion of outflows and lost over 27 per cent for the year through Dec 9, its management was compelled to adopt such extreme measures. A bond fund can underperform. But it is altogether a very different and scary thing to happen if a bond fund completely shuts shop stopping investors from taking money out.

    Reports that two hedge funds, Stone Lion Capital and Lucidus Capital, have also shut down junk bond funds in recent days are also doing rounds. Junk bond demand, which is one of seven indicators in CNNMoney's Fear & Greed Index is showing signs of extreme fear. This has caused the investors to be very worried.

    However, the Third Avenue’s measures did not come as a complete surprise for most as it seems investors had somewhat been anticipating turbulence in the high-yield market.

    Investors had already begun selling high-yield assets when the economic slowdown and market volatility in China concerns first surfaced. Anthony Valeri, fixed income investment strategist with LPL Financial opined that junk bonds are the first to to be hit at times of market volatility. He was not surprised at the latest upheaval in the junk bond market given the poor global outlook. The junk bond market has been hit bt oil slump; but Valeri feels that the present problem " goes beyond energy. Energy is a part of it.”

    Fed chair Janet Yellen has attempted to reassure investors stating that the Third Avenue fund’s problems were not exactly pervasive. She exclaims “It had many concentrated positions and especially risky and illiquid bonds.” Gary Cohn, president of Goldman Sachs seconds Yellen. Cohen feels “The Third Avenue situation is unique. They owned really low-credit-rated products to the typical high-yield fund. No one thinks that the collapse of Third Avenue is going to contaminate the world.”

    The Fed on 16th December raised rates from its record low levels which it had held steady for almost a decade. This decision of the Fed is believed to have set on track the long process of normalizing the fixed-income markets.

    Brian Battle, director of trading at Performance Trust Capital Partners is also optimistic that there is no crisis lurking around the corner. "Third Avenue had a lot of non-liquid, toxic stuff that you just couldn't sell. And the high yield market has been selling off for awhile." Battle noted.

    John Canavan, fixed income strategist with Stone & McCarthy Research Associates is confident that markets will stabilize in 2016 if the economy strengthens moderately."

    Relief swept through investors as no other bond fund thankfully collapsed post the Third Avenue shut down. Also, stock markets showed signs of modest recovery.

    Investors however need to learn their lessons from this small spark. They need to realise that there is a reason behind naming these as junk bonds. They cannot afford to get swayed by ultra-lucrative yields and take a call only after thorough study of the prevalent market condition. For example, it is a common knowledge that slump in oil price has hit energy companies hard. Thus if one has invested in high yield energy company, the investor has to be prepared to stomach the unforeseen losses that he is bound to incur. In the words of Battle, "If you can't tolerate risk and you own a high-yield energy fund, it's your own fault. It's not like you couldn't have seen this coming.”

    It will not be appropriate at this juncture to suggest that the junk bond crisis is over. If events in the past are studies it will be evident that it had taken almost a year for problems in the mortgage bond market to turn into a full blown crisis resulting in the collapse of Lehman Brothers marking the beginning of the 2007-2008 financial crisis.
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