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Wall Street to Your Street


Behind the Turbulence in the High-Yield Bond Market

The high-yield bond market has come under intense selling pressure over the past week, spooked in part by the failure of a mutual fund that had invested in some of the market’s riskiest securities. The high-yield market is now poised to finish the year with losses which, while meaningful, are not extraordinary by historical standards, especially considering that they follow six consecutive years of gains. It will be unusual, though, for high-yield bonds to post an annual loss when the economy is not in a recession.

Prices for high-yield bonds – and for leveraged loans, which share similar trading characteristics – actually began deteriorating in February following steep declines in the price of oil and many other commodities. Those declines damaged the credit quality of energy-related bonds, which represented the largest sector of the high-yield market at the start of the year, accounting for about 14% of all high-yield assets. Losses in the energy sector were sufficient to pull returns for the broader high-yield market lower. Through mid-December, the energy sector had posted a year-to-date loss of about 11%. The broader market was off much less, down about 4.5% as measured by the Barclays High Yield Bond Index.

Beyond collapsing commodity prices, the market for high-yield bonds has been squeezed this year by reduced liquidity in the capital markets, which makes it harder to buy or sell bonds without exaggerating their price swings. The liquidity crunch, in turn, can be traced in part to recent regulatory reforms, that have prompted banks that act as bond dealers to hold fewer bonds in their trading inventory. Extraordinarily low market yields also have contributed to diminished trading activity. The end result has been a more volatile bond market, punctuated by short periods of gapping prices.

While the high-yield market has been soft since February, selling pressure accelerated in the past week after the Third Avenue Focused Credit Fund announced that it would temporarily suspend shareholder redemptions while it liquidates its assets. Had it not suspended withdrawals, the fund suggested, it likely would have had to sell off its assets at fire-sale prices. Rattled by Third Avenue’s decision, short-term investors in other high-yield funds, particularly exchange-traded funds, began selling their holdings, perhaps hoping to get out of the market before Third Avenue’s liquidation sale – and any similar sales that might be undertaken by hedge funds and other institutional investors – depressed prices even further. This created a negative short-term cycle of selling that pushed prices systematically lower.

A few mitigating factors are worth noting. First, although prices for high-yield bonds have fallen, actual trading volume at these lower prices has been minimal. Also, the mutual fund that suspended shareholder redemptions is hardly a mainstream high-yield fund. Its advisor has a long history of investing in distressed and illiquid investments, and the fund itself holds a fairly concentrated portfolio of very high-risk and unrated bonds, many of which would likely be classified as illiquid under Securities and Exchange Commission guidelines. Nonetheless, its failure has roiled the entire high-yield bond market and risk assets in general.

More broadly, bouts of illiquidity and price volatility are not unusual in the high-yield bond market or in other higher-risk assets, particularly at year-end, when tax-loss selling is commonplace. In 2008, the last time it posted a negative return for the year, the Barclays High Yield Bond Index lost 26.16%. For disciplined long-term investors, these periods of volatility can sometimes create buying opportunities.

Right now, the yield on the Barclays High Yield Bond Index is about 8.7%, or about 6.7 percentage points above the yield on U.S. Treasury bonds. Excluding the distressed energy sector, high-yield bonds are yielding about 8.0%, or about 6.1 percentage points more than Treasuries. This yield spread is about 2.5 percentage points higher than the long-run average. Given the diminished liquidity in the market, overall investor anxiety, and year-end tax-loss selling, further price declines would not be surprising. But longer-term, on a valuation basis, high-yield bonds and leveraged loans look somewhat attractive right now relative to other higher-risk assets.

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