Junk Rhymes With Subprime

On December 16^th 2008, in what Ben Bernanke averred took a tremendous amount of “moral courage”, the Federal Reserve officially arrived at its Zero Interest Rate Policy.ZIRP was a huge win for borrowers because it drove down the carrying cost of debt to historic lows. Unfortunately, savers didn’t fare as well.

Those frantic savers were forced to reach for yield far out along the risk curve. And an obliging Wall Street issued over $1 trillion in new junk bonds at the lowest spreads to Treasuries in the 35 year history of the junk debt market. To put this in perspective, the entire high yield market had previously hit its frothy peak of $1.2 trillion in the bubbly days of 2007, in October of last year junk bond debt alone hit $1.7 trillion, adding to the total $2.6 trillion high yield debt market.

Through these newly issued Junk-bonds investors generously financed America’s shale boom that is now going bust. Junk debt also provided the lowest-grade borrowers cushy terms such as covenant-lite offerings and PIK (Payment-in-Kind toggle), which allows issuers to pay some of the interest due by borrowing new debt. And also financed lavish dividend payments for those debt holders.

But now the Fed’s mission is to prove to Wall St. and Main St. that nearly eight years’ worth of ZIRP has succeeded in saving the economy. Therefore, it has finally embarked on its path to interest rate normalization. However, on the way down this road to normalization the junk debt market has started to discount increased borrowing costs and a U.S. recession, which is the bane for high-yield debt.  

The carnage has just begun. Lucidus Capital Partners—an investment manager specializing in corporate credit–recently announced it was liquidating its entire portfolio and returning $900 million to clients next month. Third Avenue rattled markets when it announced December 9th that it’s liquidating a $788.5 million corporate debt mutual fund and delaying distribution of investor cash to avoid even bigger losses.  And Stone Lion Capital Partners has also halted cash redemptions for its investors.