NEW YORK, Dec 18 (IFR) - The collapse of Third Avenue’s high-yield fund did not spark the junk bond meltdown that some had feared, and a knee-jerk sell-off in fact brought buyers back to the asset class.
The sudden collapse of the US$800m Third Avenue Focused Credit fund - the largest mutual fund failure since 2008 - helped to push high-yield spreads out to four-year highs.
Prominent investors, including Janus Capital’s Bill Gross and Omega Advisors’ Leon Cooperman, now say that junk-bond valuations are starting to look attractive compared with stocks.
“From a fundamental standpoint, I like the high-yield market more today than I did last week or a month ago or two months ago,” said Matt Freund, a portfolio manager at USAA.
Yet the problems still facing the junk sector are many - not to mention last week’s new wrinkle in the shape of a rates rise from the US Federal Reserve that could also end up hiking defaults in 2016.
Commodity prices remain depressed, retail investors remain nervous, and junk-rated bond sales are closing out the year around 16% off the volumes seen in 2014.
And calling the bottom of a market that has consistently surprised to the downside this year is no easy task - especially as many deals expected early next year carry significant risk.
“Double or Single B issuance could be well received in January, but we don’t want to be in ‘melting ice cube’ business models,” said Wes Sparks, head of US fixed-income at Schroders, referring to companies whose returns are likely to dwindle over time.
“In some cases, we are just not buying (debt backing) leveraged buyouts.”
The Fed’s first interest rate increase in nearly a decade on Wednesday - and more to the point, the others that could follow - could put pressure on debt servicing costs for the most highly leveraged borrowers in the market.
“The first hike itself doesn’t concern us as much as the fact that the Fed is likely to be raising interest rates in an environment where high-yield issuers are as levered as they have ever been and are struggling to grow their earnings,” Bank of America Merrill Lynch analysts wrote this week.
The oil price collapse has done as much as anything to cloud the picture for high-yield, as so many energy companies took on new debt when crude was high - and expected to stay there.
Hopes for a turnaround seem unrealistic for now, which means the high-yield sector is likely to continue to struggle.
US benchmark crude fell below US$35 per barrel on Monday for the first time in nearly seven years, sending the yield on BAML’s main junk bond index past 9%. The index’s energy component saw its average yield top 15%.
“What is different this time is how protracted the downturn has been,” said Leslie Biddle, a partner at hedge fund Serengeti Asset Management. “The financial crisis felt extreme, but it was more like having a tooth pulled than having all of your teeth slowly decay in your mouth.”
The prolonged slump in oil prices is expected to trigger an uptick in defaults and bankruptcies, making any rebound in the sector even less likely.
“I think it would be hard to see a big rebound in healthcare, retail, cable and the overall high-yield market without oil pricing stabilising above US$40,” Biddle said.
Still, many on the buyside say that the stresses seeping through high-yield provide a chance for savvy investors to find extremely attractive valuations.
Freund of USAA told IFR that his outfit had been able to comfortably meet liquidity requirements though a combination of cash, liquid investment-grade bonds, exchange-traded funds and stocks.
“Putting all those buckets together, we haven’t been forced sellers, and we have been able to look at panics like these as opportunities,” he said. “But you really have to look at it on a bond-by-bond basis.”
As Freund indicates, those tempted to buy in now are doing so with big liquidity cushions and in names that they feel comfortable holding for a while.
But with the headwinds facing the sector - and the ink barely dry on the Fed’s historic rates hike - many say now is no time to take the plunge.
“Even with the reset of the past few weeks, I don’t think investors are being compensated with enough yield for the risks they are taking,” said George Schultze of Schultze Asset Management, which specialises in distressed assets.
“Now with interest rates starting to go up, all of a sudden the emperor has no clothes.”
A version of this story will appear in the December 19 issue of IFR Magazine, a Thomson Reuters publication (Reporting by Davide Scigliuzzo; Editing by Natalie Harrison, Marc Carnegie and Matthew Davies)