"Nobody Could Have Possibly Seen This Coming"

We have been watching the market's "sudden panic" about the implosion in the junk bond space with bemused detachment because, for the better part of the past year, we have been warning that this is about to take place. Here is a modest sample of articles from the past year commenting on the dangers from junk:

And so on.

All this culminated with a recent piece titled simply: "How To Profit From The Coming High Yield Meltdown."

To be sure, now that the carnage has been finally appreciated, everyone is on it. Cue Bloomberg:

Debt of struggling companies has slumped, with one market gauge falling to a six-year low, as declining energy and commodity prices hit producers just as the Federal Reserve prepares to raise borrowing costs for the first time in almost a decade. Scott Minerd, global chief investment officer at Guggenheim Partners, predicts 10 percent to 15 percent of junk bond funds may face high withdrawals as more investors worry about getting their money back. He joins money managers Jeffrey Gundlach, Carl Icahn, Bill Gross and Wilbur Ross in warning of more high-yield trouble ahead.

However, in all honesty the warnings were there for those who cared long ago and not just on this website. Back in July, the WSJ wrote:

Reef Road Capital LLC, led by former J.P. Morgan Chase & Co. proprietary trader Eric Rosen, has been betting against, or shorting, exchange-traded funds that hold junk bonds and buying options that will pay off if the value of these high-yield securities falls.

 

“They are going to be toast,” David Tawil, president of hedge fund Maglan Capital LP, said of the funds holding hard-to-sell assets like emerging-market debt and small-capitalization stocks. “It will be one of our first levels of shorting the moment we start to see cracks, because it’s ripe with retail, emotional investors.”

 

In a way, the moves resemble efforts by some hedge funds to find a way to wager against the U.S. housing market ahead of the financial crisis. At the time, the country brimmed with highly indebted homeowners who had been encouraged to borrow more in a low-interest-rate environment... The risk now is that this latest era of low interest rates has made risky junk bonds, which pay relatively high returns, disproportionately attractive for investors.

And then there was everyone else.

Here is an extensive selection of various warnings noted over the past year which cautioned everyone that a rout in junk is coming courtesy of Deutsche Bank.

Here are the hedge fund suggestions to go short the high yield space:

  • April 2015, Pacific Alternative, Ross associate director, "Although ‘bank-run’ risk exists in all mutual fund structures because the investors in them have daily liquidity, the risk is heightened with liquid alts due to the relative novelty of the strategy to the retail investor"
  • July 2015, Apollo, "ETFs and similar vehicles increase ease of access to the high yield market, leading to the potential for a quick ‘hot money’ exit"
  • July 2015, Maglan Capital, Tawil President, "They (the funds holding hard-to-sell assets) are going to be toast“ “It will be one of our first levels of shorting the moment we start to see cracks, because it’s ripe with retail, emotional investors"
  • 8 December 2015, DoubleLine, Gundlach co-founder, "We’re looking at some real carnage in the junkbond market" "This is a little bit disconcerting that we’re talking about raising interest rates with the credit markets in corporate credit absolutely tanking. They’re falling apart"
  • December 2015, Legal & General Investment Management, Roe head of multi asset funds, "The problem dates back to the financial crisis, as there is not the liquidity in the market to cope with a wave of redemptions and investors know this" "We saw this kind of thing before in 2008-09 in the property market, when a number of funds had to be closed because of liquidity problems"
  • December 2015, USAA Mutual Funds, Freund CIO and portfolio manager, "A precursor of a period of substantial defaults"
  • December 2015, Lehmann Livian Fridson Advisors, Fridson money manager, "It’s significantly bad news for the market, and another straw on the camel’s back" "It’s not typical, but it raises the question: Can this happen to the next-worst fund? You just don’t know. It certainly doesn’t encourage people to put money in, and that just exacerbates the liquidity problem there"
  • 10 December 2015, Carl Icahn, "The meltdown in High Yield is just beginning"

Here are official regulators warning about "run risk":

  • 8 October 2014, IMF, "Capital markets have become more significant providers of credit since the crisis, shifting the locus of risks to the shadow banking system. The share of credit instruments held in mutual fund portfolios has been growing, doubling since 2007, and now amounts to 27 percent of global high-yield debt. At the same time, the fund management industry has become more concentrated. The top 10 global asset management firms now account for more than $19 trillion in assets under management. The combination of asset concentration, extended portfolio positions and valuations, flightprone investors, and vulnerable liquidity structures have increased the sensitivity of key credit markets, increasing market and liquidity risks" ... Redemption fees that benefit remaining shareholders are one option; however, the calibration of such a fee is challenging and to the extent possible, should not be time varying, as this could encourage asset flight. Similarly, gates to limit redemptions appear to solve some incentive problems, but may simply accelerate redemptions ahead of potential imposition and lead to contagion"
  • 10 October 2014, IMF, Lagarde Managing Director, "There is too little economic risk taking, and too much financial risk taking" "One side effect is the danger, once again, of a rush toward reckless risk taking. While there are a number of warning signs, the risks are particularly acute in the nonbank sector. One example: mutual funds now account for 27 percent of global high-yield debt, twice as much as in 2007. This is larger than the world’s largest economy—the United States. History teaches us a clear lesson—the bigger the boom, the bigger the bust. A sudden shift in sentiment could easily cascade across the entire globe"
  • 18 February 2015, FRB, Powell Governor, "Caution on the part of supervisors is certainly understandable here. It is worth  remembering that the destructive potential of the subprime mortgage market was not obvious in advance and not fully reflected in real-time measures of balance sheet exposure" "Mutual funds that invest in fixed income assets have seen large inflows and have become more significant investors in this market. Some of these funds, including those holding syndicated leveraged loans and high-yield bonds, provide investors with what is called "liquidity transformation"--providing daily liquidity even when the underlying assets are relatively illiquid. The risk is that, in the event of a shock or a panic, investors will demand all of their money back at the exact time when the liquidity of the already illiquid underlying assets deteriorates even further. Investors may not anticipate or recognize this problem until it is too late--the so-called liquidity illusion" "Bank loan funds, which attract retail investors and offer daily liquidity, now total about $150 billion, or 20 percent of institutional leveraged loans outstanding.... supervisors and market participants have raised valid concerns that stressful times could well bring large-scale redemptions and threaten runs.
  • 2 June 2015, Goldman Sachs, Cohn COO, "I am concerned like many others that there's a rather large imbalance being created between the daily liquidity in the AUM (investment trust) world and the broker-dealer liquidity available to that world" "The industry as a whole has been shrinking their balance sheets because of regulatory constraints and the ability for dealers to create liquidity because of other regulatory constraints that are not balance sheet are kicking in, and we're implementing those too. And I think there's a relatively large disconnect happening there. And you don't see it most days. If you ask me how liquidity is on a normal day, I would say normal day liquidity is quite normal. The problem is on the days when you need liquidity, it probably won't be there"
  • 3 September 2015, FAC (Federal Advisory Council), "Under normal conditions in well-functioning markets, banks will provide necessary liquidity, but under stress, liquidity shortage may be very problematic. Liquidity constraints may become more apparent as interest rates rise in the coming months and years to more normal levels" "High-yield bonds, in particular, are prospectively the asset class where illiquidity will become most acute in a downturn"
  • 7 October 2015, IMF, "Changes in market structures appear to have increased the fragility of liquidity. Larger holdings of corporate bonds by mutual funds, and a higher concentration of holdings among mutual funds, pension funds, and insurance companies, are associated with less resilient liquidity"
  • 3 December 2015, FRB, Fischer Vice Chairman, "Valuation pressures had been high for a while, before risk spreads widened and issuance slowed over the past year" "The high issuance of corporate debt in recent years is evident in the near-record-high debt-to-asset ratios at speculative-grade and unrated corporations, making this sector vulnerable to adverse shocks"

And even the regulators chimed in about the quality of underlying "junk" assets and levered loans:

  • 21 May 2013, U.S. Treasury Secretary Lew, "The issuance of high-yield bonds reached a historical high in the fourth quarter of 2012. While underwriting standards remain conservative in many markets, there are some examples of loosening standards"
  • 25 February 2014, FRB, Tarullo Governor, "High-yield corporate bond and leveraged loan funds, for instance, have seen strong inflows, reflecting greater investor appetite for risky corporate credits, while underwriting standards have deteriorated, raising the possibility of large losses going forward"
  • 18 June 2014, FRB, Yellen chair, "With respect to financial stability, we monitor potential threats to financial stability very, very carefully, and we have spoken about some - I’ve spoken in recent congressional testimonies and speeches about some threats to financial stability that are on our radar screen that we are monitoring, trends in leverage lending and the underwriting standards there, diminished risk spreads in lower-grade corporate bonds. High-yield bonds have certainly caught our attention. There is some evidence of reach for yield behavior. That’s one of the reasons I mentioned that this environment of low volatility is very much on my radar screen and would be a concern to me if it prompted an increase in leverage or other kinds of risk-taking behavior that could unwind in a sharp way and provoke a sharp, for example, jump in interest rates."
  • 7 October 2014, NY fed, Federal Reserve Bank of New York, Dudley President, "We are following up with those banks to see how closely they are following the guidance (regarding standard of leveraged loan)" "We think the market is a bit frothy"
  • 18 February 2015, FRB, Powell Governor, "Investors may take highly leveraged positions in leveraged loans through total return swaps and secured funding transactions, and a substantial buildup of these positions could present run and fire-sale risks if asset values started to fall.... "Another issue to consider when contemplating such intervention is that, particularly in the United States, activity is free to migrate outside the commercial banking system into less regulated entities. As supervisory scrutiny has increased in recent years, a growing number of nonbanks have become involved in the distribution of leveraged loans."
  • 6 May 2015, FRB, Yellen chair, "I would highlight that equity market valuations at this point generally are quite high" "There are potential dangers there" "Long-term interest rates are at very low levels, and that would appear to embody low term premiums, which can move, and can move very rapidly" "When the Fed decides it’s time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates"
  • 22 October 2015, Bank of England, Cunliffe Deputy Governor: Challenge for the market: "A particular concern occupying both the (BoE's) Financial Policy Committee and authorities internationally is that simultaneous redemptions from open-ended funds offering short-term redemptions could test the resilience of market liquidity" "It is quite conceivable that given the range and speed of regulatory reforms, there are parts of the framework that might not work in the way we intended"

Finally, ETFs:

"ETFs are another form of financial engineering that have grown rapidly over the past decade or so – from a small base in the early 2000s to more than US$2 trillion today. Equity funds still comprise the majority of ETFs. But the share of fixed income ETFs, in which the underlying assets are much less liquid, has grown substantially – in Europe, from around 5% in the early 2000s to around 25% today” “In times of stress not only can their liquidity characteristics revert back to that of their underlying assets, they can also trade at a discount to the value of these assets. We saw some of this effect in the market turmoil last summer. We need to understand better why these effects happened and the circumstances in which they could reoccur"

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All of the above? Ignore, as our friend Eddie Morra sarcastically remarks:

Bottom line, if junk bonds end up being the precursor to a wholesale market swoon or something even more serious, one can be certain that the common refrain from all the financial "experts" will be a very well known one:

"nobody could have possibly seen this coming."