Junk Bond Meltdown

Divergence Sell Signal

In his recent article titled "This chart warns that stock market investor should be on high alert," Tom Kilgore demonstrates the connection between the junk bond market and the equity market.

“High yield corporate bonds are thought by many to behave like the rest of the bond market, but they actually behave a lot more like the stock market,” Tom McClellan, publisher of the investment newsletter McClellan Market Report, wrote in a recent note to clients. “And when high-yield bonds start to suffer, that is usually a reliable sign that liquidity is drying up, and bad times are about to come for the stock market.”

“impractical” for the fund to pay off departing investors without selling holdings at fire-sale prices “that would unfairly disadvantage the remaining shareholders,” David Barse, chief executive of Third Avenue Management LLC, wrote in a letter to shareholders dated Wednesday.“Most mutual-fund investors are under the presumption that their money is available for them at a moment’s notice,” says Jeff Tjornehoj, head of Americas research at Thomson Reuters Lipper. While investors understand that the higher yields of junk bonds come with risks, he said, “I don’t think many of them ever plan on a fund blowing up like this.”

“The meltdown in High Yield is just beginning," Icahn, who’s been betting against the high-yield market, wrote on his verified Twitter account Friday.

Icahn’s comments come as junk-bond investors, already stung by the worst losses since 2008, are the most nervous they’ve been in three years after Third Avenue Management took the rare step of freezing withdrawals from a $788 million credit mutual fund.

Five Troubling Signs for the Junk Bond Market

In her recent article, Ciara Linnane highlighted five signs the "junk-bond market is in big trouble."

1.  "After pouring money into junk-bond funds the past several years in a desperate hunt for yield, investors have started to run for the exits."

2.  "Yields have continued to shoot higher this week, especially at the lower end of the credit spectrum. In the CCC category, which is five rating notches below investment grade, yields spiked to 17% this week, their highest level since 2009."

3. "The BofA U.S. High Yield Master Index has been showing negative returns since September and is now firmly in the red, making it almost certain investors will lose money on the asset class this year for the first time since 2008."

4. "The number of global corporate defaults this year rose to 102 issuers in the latest week, its highest level since 2009."

5. “A portfolio manager who turns negative on a name and decides to liquidate a large position must be resigned to disrupting the market more violently than would have been the case before the Global Financial Crisis,” said Marty Fridson, chief investment officer at wealth manager Lehmann Livian Fridson Advisors LLC, in a recent report published by LCD.

Conclusion

Junk bond spreads are wide and are continuing to widen; downgrades are also increasing. Why? Because bankruptcies are at levels not seen since the great recession. Junk bond investors are headed for the exits and experts like Carl Icahn believe “The meltdown in High Yield is just beginning." Junk bond liquidity has dried up, which has begun to force junk bond funds to liquidate. In other words, fund managers are unable to sell their positions fast enough (at reasonable prices) to keep up with redemptions.

Perhaps the most important observation: junk bond market downturns have historically led both U.S. recessions and major equity market selloffs. Alarmingly, we are seeing a major divergence between the two markets right now.

How is the equity market responding? As I write this, the S&P 500 index is up well in excess of 1% today. Only the rookie portfolio manager's are working this week and they are apparently still gorging themselves with eggnog and sugar cookies. Perhaps when the experienced investment managers return next week, we will see a more reasoned evaluation of market risk.

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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