EC Junk Bond Risk Leading To A Potential ‘Blood In The Streets’ Environment

Investor attention at the end of last week’s trading was focused on the sharp sell off in high yield bonds, better know as junk bonds. This sell off was precipitated by the firm, Third Avenue, restricting redemptions on its Focused Credit Fund. Subsequent to Third Avenue’s announcement, Stone Lion Capital Partners L.P. said it suspended redemptions in its credit hedge funds due to the high level of redemption requests it has received. Many stories have been written about the events impacting the high yield bond market, here and here. 

In reality, a better classification for the Third Avenue Focused Credit Fund is probably a distressed debt fund or special situation fund. The fund’s “focused credit” reference means just that, the fund is highly concentrated with nearly 30% of the fund’s assets invested in its top 10 bond holdings. In other words, the fund is not a diversified bond fund. Our clients know we eliminated our high yield bond exposure in July of 2014. One reason we sold the high yield exposure last year was due to the narrow spreads on high yield broadly as reflected by the red dot in the below chart. This tight spread characteristic is an indication of the rich valuation of the high yield asset class at that time.

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The issues surrounding high yield are being felt in the equity market as high yield bonds and stocks are highly correlated. Last week the Nasdaq declined 4.1% with the S&P 500 Index and the Dow Jones Industrial Average both declining 3.8% and 3.3%, respectively. For the year both the Dow and S&P 500 Index are essentially flat for the year on a total return basis while the Nasdaq remains up a little over 4.0% year to date. On a price only basis the S&P 500 Index is down 5.6% from its high in May.

The pullback last week has resulted in the CBOE Equity Put Call Ratio spiking higher to .92 as can be seen in the chart below. As I have noted in earlier posts, P/C ratios over 1.0 are representative of an oversold market. The second chart shows the VIX index and this fear measure has also jumped higher to 24.4. Readers can track these fear measures here.