December 13

Red Alert For Junk Bonds

Fear rippled through financial markets last week as the $788mm Focused Credit Fund high yield bond fund managed by Third Avenue raised the gates and barred redemptions until the fund is wound down. Markets responded violently to this move as it seems to have been related to Oil’s 12% decline on the week which officially put US Oil frackers on bankruptcy watch, now exposing billions of dollars of junk bonds to huge losses. This move triggered a broad wave of selling on Friday, sending Oil to fresh lows down to a close of $35.66. The high yield SPDR exchange traded fund JNK saw it’s worst day of the year falling 2.01% which is a huge move for the bond market.  The selling in stocks was concentrated in energy and overvalued tech names with NFLX, AMZN and FB all down over 3%. The US Dollar continued to lose ground along with commodity currencies as USDJPY dropped below 121, finally springing to life after a month in the 122.50-123.50 range.

It has been almost five years since a systemic risk roiled investor sentiment, with the last episode being the Fall 2011 downgrade of the US credit rating along with the Italian debt crisis. This week’s risk aversion sprang to life as Oil finally cracked below $40 a barrel. This level was seen as the “price of last resort” for North Dakota and Texas oil fracking operations with break evens very close to and around the $40 per barrel area.

As oil continues lower it is becoming apparent that a large wave of defaults may hit the junk bond market in the coming months. Massive amounts of debt have been issued by small and medium sized drillers in the last five years at very favorable interest rates in the mid single digits. Many of these bonds have already blown up and now pay yields as high as 17%. Energy bonds are around 18%-20% of most diversified junk bond funds, and as this portion of the market sells off investors rush to redeem their money forcing the entire spectrum of bond holdings in the fund to be sold off. Materials and retailers have also been especially weak credits in the last month. We mentioned here in the past the huge illiquidity risk in the corproate bond market, and Friday’s price action showed just how risky these securities are. There is nobody around to trade them, and the Street has no balance sheet to dedicate to buying huge amounts of bonds everyone wants to sell at the same time.

Looking forward,  the US Dollar looks vulnerable to a continued correction or possible near term top. The Dollar index double topped out around the 100 level, and has been declining ever since Draghi’s big disappointment at the last meeting. There are still very large USD long positions as reported in Friday’s CFTC report, with EUR shorts surprisingly still very elevated. As I have been stating on twitter for months, the US Dollar is tied at the hip with stocks and risk sentiment due to the fact that so much of the rate hike cycle is already priced into the Dollar’s valuation. As risk sentiment deteriorates the Dollar could continue to sell off.