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Current Junk-Bond Turmoil just Preliminary, 'Prisoner Dilemma' Ensues, but “The Real Panic Will Come With…”

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Wolf Richter   www.wolfstreet.com   www.amazon.com/author/wolfrichter

Suddenly there’s a laundry list of what went wrong. A “more hawkish Fed stance, heightened geopolitical risks,” Argentina’s default, another bank collapse and panicky bailout in Europe (Banco Espirito Santo), “and concerns over stretched valuations,” wrote Matthew Mish, Head of Credit Strategy at UBS Investment Bank, and Thibault Colle, Associate Credit Strategist; it triggered “a cascade of mutual fund outflows in recent weeks.”

They weren’t exaggerating. Investors yanked $7.1 billion out of junk bond funds in the week ending Wednesday, a record amount, according to Lipper. This has been going on since early July, and junk bond prices have dropped, yields have jumped from all-time lows, and yield spreads have suddenly widened. After having been inflated to dizzying proportions, the junk-bond bubble has been pricked. And the hot air is hissing out of it.

This chart by UBS is a picture of investors suddenly bailing out while they still can. The vicious taper tantrum of last summer looks comparatively tame:

US-junk-bond-fund-flows+spreads_UBS

Neither glorious economic fundamentals nor corporate financial engineering caused investors to pile helter-skelter, eyes-closed into this high-yield junk. The Fed’s financial repression did.

The Fed has made it impossible for yield investors to earn a noticeable return above the rate of inflation with low-risk paper. So they chased after whatever yield they could get and they held their noses and ventured deeper and deeper into a swamp they normally wouldn’t want to be in. They did that in unison. The demand they created for junk drove up valuations and repressed yields further into low-yield purgatory, where potential losses are huge and potential gains very meager. Exactly as the Fed had wanted them to.

But the Fed has changed its mind. And it’s communicating it on a near daily basis [read... Fed’s Fisher: End of ZIRP moved ‘further forward’]. The force that has driven up the junk bond market and that has allowed overleveraged corporations to sell a mountain of junk bonds at record low cost is in the process of disappearing: QE will be tapered out of existence this fall; ZIRP will be whittled down later. Instead of the Fed’s free money flowing into the high-yield market, money is now draining out of it.

In this chart by UBS, the cumulative junk-bond fund flows (light-gray line, left scale) ballooned in parallel with the Fed’s balance sheet (dark line, right scale). But look at the top right-hand corner: as the dark line is flattening out, the light-gray line broke off like a dry twig.

US-junk-bond-fund-flows+Fed-balance-sheet_UBS

In their note – chillingly titled, “Is the US high yield bond theatre on fire?” – the authors warn that investors “no longer have the Fed at their back,” just when “corporate leverage has bottomed as profits move sideways while net debt rises.”

As spooked investors – many of them conservative yield investors driven into junk bonds by the Fed’s relentless financial repression – are trying to dump their holdings before everyone else does, the problem of market liquidity arises: it has been evaporating.

Junk bond assets in mutual funds and ETFs have nearly tripled since the bottom of the financial crisis, while inventories at dealers have collapsed as many of the big banks have largely withdrawn from the fray. Market makers packed up their marbles and went home, while companies sold dizzying amounts of new junk debt at record high prices to investors blinded by the Fed’s financial repression.

US-junk-bond-funds-v-dealer-inventories_UBS

So when these spooked investors are trying to sell, who is going to buy? Yields are still near historic lows, after nearly six years of QE and ZIRP that are now drawing to an end. But higher yields and lower prices – and higher default rates, according to Fitch – are lined up into the horizon as far as the eye can see. There are not going to be a lot of eager buyers.

“Simply put, one cannot enter and exit positions freely,” the authors explained with razor-sharp calm. Instead, investors are stuck and become “more buy-and-hold in nature.” In doing so, they could get hosed.

This arguably creates a prisoner’s dilemma. Investors have a choice. If they do not sell, and others do not sell, then market stability will likely result and historically low valuations could persist for a while longer. However, given challenging liquidity conditions and warnings from the Fed and others of a market ‘bubble,’ investors cannot overstay their welcome. If some of them decide to sell, then they can hope to exit before others – but risk causing a stampede of outflows.

And that stampede has already started. UBS sees “few signs of stabilization.” Instead, “headline risk will persist around the Fed’s stance as it finishes tapering and has to outline its exit strategy….” Eurozone banks are facing the ECB’s stress tests, and results will likely be out in October or November. And the asset allocation strategists at UBS “are tactically calling for a bout of risk-off.”

But the current turmoil in the junk bond market is just some preliminary pushing and shoving:

The real panic will come with a more severe downturn in credit and economic fundamentals, which will likely trigger an exodus from non-institutional and crossover/tourists from US high yield. That moment is unlikely to be a 2014 event….

OK, so maybe not this year. Unless everybody is afraid to wait till next year and starts selling now to be among the first ones out. Because everyone knows that in bond funds, the first ones out win.

When redemptions start as prices fall, funds dip into cash and sell the most liquid bonds that have lost the least value, and the first batch of investors get out scot-free. As redemptions continue, the less liquid bonds have to be sold into an illiquid market, and prices plunge. Junk-bond funds that get hit by massive redemptions over a long period of time can punish the late sellers and the forced “buy-and-hold” investors brutally. That’s the effect of the “prisoner dilemma.”

And since everyone knows this, investors might be trying to get out early, thus triggering the very event – the “stampede of outflows” - that will punish investors behind them the most.

When Ben Hunt, Chief Risk Officer of Salient Partners, spent a few weeks traveling across the country and meeting with clients – investment advisors and professional investors – to understand their thinking about the markets, he found that a fascinating phenomenon had become near universal among these professionals, a phenomenon with a potentially dreadful outcome. Read…. ‘Faith’ in Markets Collapses Among Professional Investors

 

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Sun, 08/10/2014 - 03:24 | 5072101 SpinDrift
SpinDrift's picture

I was raised to work hard, save my money, and to never buy junk. Stupid is as stupid does?

Sat, 08/09/2014 - 03:45 | 5069205 hedgiex
hedgiex's picture

Not exactly true that the Fed singly caused the rush to the junk bond space. There have been asinine lap ups to the snake oils sold by financial predators. See this in the inflows: foreign funds flows into these toxics have been low vs domestic funds. Domestic funds from the crowd (including the mutual funds, 401K) have been higher than the smart monies.

The same lemmings are still fed to stay despite omnious signs of reg lobbies that their monies will be gated in any crowd exits.

 

Sat, 08/09/2014 - 10:08 | 5069550 weburke
weburke's picture

not to worry, we are good for another full year. 

Sat, 08/09/2014 - 00:57 | 5068995 Downtoolong
Downtoolong's picture

investors might be trying to get out early

And go where? Nowhere, that's where. Stocks, Government Bonds, commodities, it's all overpriced shit. Try to get out early and next day it's "OK, everybody back into the cesspool", because, the swamps, tarpits, dead seas, and lava flows we just jumped into are even worse.

 

 

 

Sat, 08/09/2014 - 07:21 | 5069329 messystateofaffairs
messystateofaffairs's picture

Run for the hills, thar's gold in them thar hills. Could buy a few hills as well, especially if there is water and farmland on them.

Sat, 08/09/2014 - 09:58 | 5069525 new game
new game's picture

Not only gold, but any physical necessity that keeps a human alive! Land with water below. A place to live, ha-duh. Think deflation/inflation! Deflating values of risk/shit/paper! Think inflating must have stuffs! Go to the hardware store and do a 360 and start buying what you don't already have, then swing by your favorite ammo depot and stock up. Land lead gold(llg).

Fri, 08/08/2014 - 23:57 | 5068913 AdvancingTime
AdvancingTime's picture

 It might soon become apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward.  When this happens we are at the end game.

At some point the return on loaning money is simply not worth the risk!  Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants.

The collapse of credit can pose major problems such as what we saw when many sellers were forced to demand payment up front before shipping goods in 2008. More on this subject below.

http://brucewilds.blogspot.com/2014/06/the-economic-efficiency-of-credit...

 

Sat, 08/09/2014 - 08:53 | 5069407 Okienomics
Okienomics's picture

You're repeating your pimping.

Fri, 08/08/2014 - 19:51 | 5068196 q99x2
q99x2's picture

I'll be ok. I started my Almased diet and found I don't need no F'n food.

Fri, 08/08/2014 - 18:02 | 5067719 scraping_by
scraping_by's picture

The problem with junk bonds is the lender is extracting loan shark level returns without loan shark methods to back them up.

If a CFO had the prospect of being waylaid on the way home some evening by a couple of mouthbreathers who explained the sanctity of debt and illustrated their point by busting his thumbs, it would be a relatively safe investment. But no, the issuers can just file a few court papers and move to the Bahamas for a few months of tanning and G and T's while investor fury runs its course.

This is a very exposed position. Makes for nervous investing.

Fri, 08/08/2014 - 21:16 | 5068499 spanish inquisition
spanish inquisition's picture

You need to split the latest loan between paying your bonus and buying back shares to boost EPS. Then borrow more money on your good EPS outlook. Rinse and repeat, then you will be able to upgrade the beach house in the Bahamas when the time comes.

Fri, 08/08/2014 - 17:04 | 5067483 Radical Marijuana
Radical Marijuana's picture

Marines will be forced to jump in the water and fight the sharks, while Obama goes back to golfing.

Fri, 08/08/2014 - 18:50 | 5067895 Zero Govt
Zero Govt's picture

the President needs more practice on the course ...and in politics too quite frankly ...his leaderships like a golf buggy without steering

'FOR'

Fri, 08/08/2014 - 21:24 | 5068529 Attitude_Check
Attitude_Check's picture

You dont need to steer when you are just along for the ride.

Fri, 08/08/2014 - 14:38 | 5066676 AdvancingTime
AdvancingTime's picture

 It might soon become apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward.  When this happens we are at the end game.

At some point the return on loaning money is simply not worth the risk!  Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants.

The collapse of credit can pose major problems such as what we saw when many sellers were forced to demand payment up front before shipping goods in 2008. More on this subject below.

http://brucewilds.blogspot.com/2014/06/the-economic-efficiency-of-credit...

Fri, 08/08/2014 - 14:12 | 5066479 LawsofPhysics
LawsofPhysics's picture

Sorry idiot, but the "end of ZIRP" will always be "just around the corner" indefinitely...

It's either that of governments in the west start defaulting in earnest.  Pick your poison.

Fri, 08/08/2014 - 14:31 | 5066600 fonzannoon
fonzannoon's picture

When investors "yanked" 7.1 billion out of junk bonds, other investors bought them, no? I'd be more interested in who the buyers were than the sellers.

http://finance.yahoo.com/q/bc?s=HYG+Basic+Chart&t=5d

Fri, 08/08/2014 - 17:27 | 5067582 sessinpo
sessinpo's picture

fonzannoon    When investors "yanked" 7.1 billion out of junk bonds, other investors bought them, no? I'd be more interested in who the buyers were than the sellers.

---

How about the issuers themselves or those thinking they are getting a discount

Fri, 08/08/2014 - 14:06 | 5066431 rocker
rocker's picture

Not to worry, Bob Pissonme says everthing is O.K. now.

Sat, 08/09/2014 - 01:56 | 5069101 El Oregonian
El Oregonian's picture

The analogy would be like riding the "Kingda Ka" at Six Flags Great Adventure in New Jersey when all of a sudden a 9.5 Earthquake hits there right in the middle of the ride... Equals = You're doing a Wiley Coyote at the end...

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