David Dayen: Is This The Beginning of the Crackup in High-Yield Corporate Debt?

By David Dayen, a lapsed blogger

I wasn’t entirely sure if the implosion this week of Third Avenue Management’s Focused Credit Fund was an elaborate advertisement for the release of The Big Short or what, but it certainly feels like a familiar early data point, not for mortgages this time but for something we’ve been tracking for a while: the high-yield bond sector.

Here are just the facts from Bloomberg:

A $788 million mutual fund is blocking clients from pulling their money so its holdings can be liquidated in an orderly fashion.

Martin Whitman’s Third Avenue Management put some of the assets in the Third Avenue Focused Credit Fund in a liquidating trust that will seek to sell them over time, the New York-based firm said in a statement on its website dated Dec. 9.

The step is unusual for a mutual fund, which typically offers daily liquidity to investors, and comes after regulators raised concerns that some mutual funds are investing in assets that could be hard to sell in a market rout. David Barse, Third Avenue’s chief executive officer, said blocking redemptions was necessary to avoid fire sales. The fund, which had $3.5 billion in assets as recently as July of last year, suffered almost $1 billion in redemptions this year through November.

The buried lede is the 77 percent drop in assets in just 18 months, from $3.5 billion to $788 million. That’s kind of the very fire sale that Third Avenue belatedly took evasive action to prevent.

I think I first wrote about the corporate debt time bomb in February 2014 for Pacific Standard. Here’s another one a month later for Salon.

I did a long exploration into leveraged loans for The Progressive in mid-2014 that they never put online – maybe I’ll post it this weekend. Here’s a taste:

Since March 2009, the junk bond market has doubled to $2 trillion, as worries about risk have flown out the window. Got an idea for a vegan restaurant on a cow farm or a lingerie shop in a nunnery? No problem, some investor will lend you lots of money…

Loans… are often “covenant-lite” leveraged loans, a type of junk bond that offers fewer safeguards for investors. Given the desperation for higher yields, investors foolishly accept higher risk to get their hands on low-grade corporate debt. So under the terms of these loans, investors do not get informed when the underlying companies run into financial trouble, making it harder to avoid losses…

Smaller and smaller firms were the beneficiaries of these loans, like Learfield Communications, a media group with $40 million in annual revenues that received an incredible $330 million in covenant-lite loans last October. It’s correct to call this the “subprime of the corporate world.”

More recently, Naked Capitalism has had Wolf Richter walking us through the coming carnage for over a year now. The basic story: the junk bonds are losing altitude, thanks mostly to losses in high-yield energy debt, with oil prices flatlined. Third Avenue’s FCF had some energy but also a number of companies acquired in large leveraged buyouts, so this is a private equity issue as well.

More and more corporate debt has become distressed, and the vultures lured into buying the wounded animals are taking their own hits now, as these companies default. Standard & Poor’s counts 102 defaults among corporate debt issuers, the most since 2009. S&P’s “distress ratio” is up to 20 percent and rising; for energy debt that’s up to 50 percent.

Late Friday, the next shoe dropped: distressed-debt specialist Stone Lion Capital froze redemptions in their oldest fund. I should note that Stone Lion is a major player in the Puerto Rican debt crisis, and this trouble, especially if it spreads to other vulture funds, could impact that situation, though I’m not certain in what direction.

Mr. Market is starting to get the willies from all this. Icahn’s nervous, too. “The meltdown in High Yield is just beginning.” Jeff Gundlach added on Tuesday, “We are looking at real carnage.”

These are really just shadow bank runs. And for a mutual fund that allows investors complete liquidity, that’s fatal. Wolf notes that there’s a big short going on here, too:

When an “open-end” bond fund starts losing money, investors begin to sell it. Fund managers first use all available cash to pay investors. When the cash is gone, they sell the most liquid securities that haven’t lost much money yet, such as Treasuries. When they’re gone, they sell the most liquid corporate paper. As they go down the line, they sell bonds that have already lost a lot of value. By now the smart money is betting against the fund, having figured out what’s happening. They’re shorting the very bonds these folks are trying to sell.

The longer this goes on, the more money investors lose and the more spooked they get. It turns into a run. And people who still have that fund in their retirement account are getting cleaned out.

I don’t know how many retail investors are exposed, but I’d bet they don’t know either. Wolf estimates the junk bond market at $1.8 trillion, so it’s sprinkled everywhere. Even Valeant’s debt is distressed.

Liquidation of Third Avenue’s Focused Credit Fund will take over a year. But it’s investors in similarly situated funds, and whether they panic, that will determine the course of this event. So far it looks pretty bad: Wolf reports that $3.5 billion in retail cash fled US junk-bond funds over the past week, $2.8 billion of that from mutual funds.

I think asking “will this be the next crisis” is in a way besides the point. All crises are not created equal. But if anything, the experts and pundits are underpricing the risk. For starters, a lot of this debt was securitized, packaged into collateralized loan obligations that were privately traded, so we have no clue of the level of risk. Many CLOs were synthetic, too, and a good number of hedge funds bought CLOs with borrowed money. So Third Avenue, and like-minded distressed-debt specialists, are one thing. The real question is how the CLO holders hedged themselves, and who else has a piece of this crap.

Traders trying to minimize the damage are moving into options, but that may not hold out. And of course we’ll have a Fed rate hike, in all likelihood, interacting with this next week.

In a sense, this is a real-economy crisis – the slow, inevitable crash of the energy sector during an oil glut – magnified by financial engineering. If you think of it that way, you can envision the battle in Congress right now over whether to lift the oil export ban as a pre-emptive bailout, as if there was a bank bailout back in mid-2006. But even lifting the ban appears to be more like applying a band-aid when you need a tourniquet. Even with the ability to export, U.S. energy producers will still have to sell into a global market, probably with even lower prices if it gooses production in the short term. That’s not going to solve the problem. And it’s not going to unwind the toxic debt instruments.

Martin Whitman, Third Avenue’s founder, literally wrote the book on distressed investing. But their investing strategy – putting high-risk investments into a mutual fund – seems like exactly what not to do, especially if a systemic downturn hit any portion of the corporate sector. I already see people trying to blame Dodd-Frank for this, and not just the usual dumb money gambling to chase returns. Brace yourselves for the next couple months as this begins to shake out.

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About David Dayen

David is a contributing writer to Salon.com. He has been writing about politics since 2004. He spent three years writing for the FireDogLake News Desk; he’s also written for The New Republic, The American Prospect, The Guardian (UK), The Huffington Post, The Washington Monthly, Alternet, Democracy Journal and Pacific Standard, as well as multiple well-trafficked progressive blogs and websites. His has been a guest on MSNBC, CNN, Aljazeera, Russia Today, NPR, Pacifica Radio and Air America Radio. He has contributed to two anthology books, one about the Wisconsin labor uprising and another on the fight against the Stop Online Piracy Act in Congress. Prior to writing about politics he worked for two decades as a television producer and editor. You can follow him on Twitter at @ddayen.


  1. MikeNY

    Yes, junk is usually the canary in the coal mine. The HY market melted in the Summer of 2008, months before equities noticed what was going on. The question really is how much contagion there will be: how many CDS have been written on the distressed names, who holds them, etc. My instinct tells me that there are considerably less CDS on junk than were written on MBS, due to the smaller market, the lower liquidity and (supposed) credit quality. But how much has that changed since 2008? I dunno.

    One thing I do know: it’s like the movie “Groundhog Day”. The Fed always overstimulates, and there always follows a crash. Are there any bubbles left to blow, to ‘reflate’ assets next time?

    1. timmy

      Your remark on written CDS is important. While it may be difficult to get liquidity on distressed names, it is less so on credit tiers above that or on indices. I’m sure there is some on junk, yes, but the real opportunity for spec CDS is (perhaps, was) on the BBB space which is the largest category in the investment grade market and is more liquid. While it may take awhile for distressed trading to creep up the credit ratings to the larger and more liquid names (specifically, since the definition of liquidity seems to be important on NC: the size of the specific issues’ float, approximated with average daily volume), they will also have larger moves because potential fallen angels are repriced aggressively in an unstable market. The other thing about CDS is that they are most often delta-hedged which requires dealers to sell proxy’s as the CDS go deeper into the money. The one restraining factor is that once a crisis is in motion, I think its going to be difficult for specs to get more CDS on their books. This strategy is purely directional (this is not an ETF NAV arb), essentially owning out of the money puts with minimal cost of carry.

    2. Jim Haygood

      ‘Their investing strategy – putting high-risk investments into a mutual fund – seems like exactly what not to do.’

      It cuts two ways. Junk ETFs such as JNK and HYG have badly underperformed their benchmarks, owing to buying and selling in an illiquid market to replicate an index. Whereas actively managed junk mutual funds have the flexibility to deviate from index holdings in ways that can add a couple of hundred basis points a year.

      That said, both junk ETFs and junk mutual funds are offering daily liquidity, while holding underlying securities that may trade once a week, or have no bids at all. As David Dayen observes, this sets up the risk of a bank run when investors get spooked.

      Take a look at the “power dive” chart of TFCIX (Third Avenue Focused Credit Fund) — Aiieeeeee!


      Now the question is contagion. Morningstar shows that 48% of TFCIX’s portfolio was below B rating, and 41% had no bond rating. Most junk funds don’t have THAT ugly a portfolio. But when the herd starts to stampede, fine distinctions can get lost in the dust cloud from the thundering hooves.

      Over to you, J-Yel. Do you feel lucky, cherie? Well, do you?

    3. Mike Sparrow

      There is no CDS. There just isn’t less, there is none. The stock market has pretty much ignored it as well except that its move from 13000 to 18000 has temporarily stalled. I suspect by the spring, this will be old news.

      I think we make errors here, not understanding this particular type of financial speculation is “anti-growth” in general. This would probably blow most of the minds on this board.

  2. Keith

    Many years ago when Alan Greenspan first proposed using monetary policy to control economies, the critics said this was far too broad a brush.

    After the dot.com crash Alan Greenspan loosened monetary policy to get the economy going again. The broad brush effect stoked a housing boom.

    When he tightened interest rates, to cool down the economy, the broad brush effect burst the housing bubble. The teaser rate mortgages unfortunately introduced enough of a delay so that cause and effect were too far apart to see the consequences of interest rate rises as they were occurring.

    The end result 2008.

    With this total failure of monetary policy to control an economy and a clear demonstration of the broad brush effect behind us, everyone decided to use the same idea after 2008.

    Interest rates are at rock bottom around the globe, with trillions of QE pumped into the global economy.

    The broad brush effect has blown bubbles everywhere.

    “9 August 2007 – BNP Paribas freeze three of their funds, indicating that they have no way of valuing the complex assets inside them known as collateralised debt obligations (CDOs), or packages of sub-prime loans. It is the first major bank to acknowledge the risk of exposure to sub-prime mortgage markets. Adam Applegarth (right), Northern Rock’s chief executive, later says that it was “the day the world changed”

    10th December 2015 – “Moments ago, we learned courtesy of the head of Mutual Fund Research at Morningstar, Russ Kinnel, that the next leg of the junk bond crisis has officially arrived, after Third Avenue announced it has blocked investor redemptions from its high yield-heavy Focused Credit Fund, which according to the company has entered a “Plan of Liquidation” effective December 9.”
    When investor’s can’t get their money out of funds they panic.

    Central Bank low interest rate policies encourage investors to look at risky environments to get a reasonable return

    Pre-2007 – Sub-prime based complex financial instruments
    Now – Junk bonds

    The ball is rolling and the second hedge fund has closed its doors, investors money is trapped in a world of loss.

    “Here Is “Gate” #2: $1.3 Billion Hedge Fund Founded By Ex-Bear Stearns Traders, Just Suspended Redemptions”

    We know the world is downing in debt and Greece is the best example I can think of that shows the reluctance to admit the debt is unsustainable.

    Housing booms and busts across the globe ……

    Those bankers have saturated the world with their debt products.

    1. Skippy

      Quality of instruments impaired by corruption has a more deleterious effect than quantities of could ever imagine…

    2. David

      “Those bankers have saturated the world with their debt products.”

      I’m no apologist for Banksters but people bought this “stuff” as the Stuffies.

      whether you call it greed or desperation in the face of zero yield – at the end of the day the horizon was short since the last debacle.

      getting 2 & 20 or whatever the comp arrangement was for those who are motivated by greed – 2% of $2 Billion yields at least $40 million a year for 5 years or $200 million – not bad for ten guys or less – obviously not fiduciaries – bouncing from Bear to Tudor to Third Ave with no change in the model yields predictable results

      I put forth the proposition the “people” deserve their fate – the tea leaves were all there to see

      1. tegnost

        Your apology is flawed because it assumes equal access to information among investors as well as assuming all investors have the same objective. Institutional investors have different goals than hedge funds for example. The people you refer to have been fleeced that’s just ok with you. As to tea leaves the people have been steeped in recovery stories for years.

        1. Ian

          Also fails to recognize the collateral damage caused towards the people that did not directly participate. It is very hard to say that they deserve their fate in this context, in that they were largely powerless to stop it to begin with, at a reasonable level.

  3. Timmy

    Wait, so speculators are shorting big bond positions of distressed funds? No way, hope they aren’t doing this to ETF’s. Jeez, didn’t see this coming. I guess having the positions of big ETF’s published daily might assist the speculators.

    1. Jim Haygood

      Yesterday HYG closed at a 0.76% discount to NAV, while JNK closed at a 0.68% discount (values from Morningstar). These are wider discounts than ETF managers like to see.

      The arbitrage mechanism of buying the discounted ETF shares, redeeming them for the underlying, and then selling the bonds at full value for an instant 0.76% gain is supposed to kick in now.

      But sell … to whom?

      1. Timmy

        The misperception is that the ETF junk trade is an arb right now. Its not, its directional. The discipline to bring NAV’s in line with underlying value will only kick in at much wider levels because traders are still long (and putting on more of) the “widener” because they anticipate higher levels of vol going forward.

  4. tegnost

    Actually have already been bracing myself as demand for labor fell off a cliff at the end of sept., and I’m guessing it’s stories such as this that makes my customers tighten their belts. It’s an interesting engineering phenomenon that some of nc’s actual engineers could describe better, but I’ll give it a shot. In Seattle the highway system has congestion speed limits, so as you enter seattle there are signs over the roadway with speeds, 55, 50,45,30 etc… telling you to maintain the speed on the sign. The idea is that brake lights cause traffic jams, the impulse for drivers is if you see a brake light ahead you put on your brakes, which indicates to someone 20 cars behind you to put on their brakes, and so on, we’ve all seen it happen, instant traffic jam. Over the summer I heard a few grumbles, no money in bonds, too much exposure in stocks (as in the market can crash while you’re out riding your bike and you get cleaned out, why gentlmen prefer bonds as I understand it, which is not very well). So to point, the cages were getting rattled over the summer, projects that had already been started were finished, but no new projects, i.e. brakes lights. More astute commenters can probably fill in the blanks from both the engineering and bond investment angles, but this canary is sensing a low oxygen environment…

    1. bob

      You don’t use brakes on interstates unless you absolutely have to.

      Keep your distance and pay attention.

      I don’t brake when I see brake lights, I get in front of the asshole who doesn’t know how to drive.

      If you can’t slow down fast enough by taking your foot off the gas, you are A) driving too fast B) following too closely. Most likely both.

      There is something between the gas and the brake- nothing. Just do nothing. You will slow down. This is pre-driver’s ed level stuff.

      If this is anathema to you- you need to stop driving. Now, Today.

      And, if you are in the left hand lane (PASSING LANE) and use your brakes, you should be immediately shipped off to a re-education camp.

      1. harry

        I’m struggling to follow the extension of the metaphor. Did we stop talking about trading bonds and the economy?

    2. Gio Bruno

      The idea is that brake lights cause traffic jams

      Actually, traffic engineering is a bit more complicated than that. The Feds have done massive amounts of analysis of traffic flow on highways (Interstates) and the optimal full capacity flow is 45 MPH (not 65 MPH). Add in on/off ramps and resultant weave motion (lane changes) and the optimal speed is reduced (thus the 45, 35, 30 signage). Avoiding congestion on the highway requires avoiding congestion on side-streets (on-ramps), also.

      So, these “sharpies” playing with CDO’s and risky corporate debt are ignoring the “collateral damage” of their speeding in the financial service zone.

  5. nat scientist

    “Some say the world will end in fire
    Some say in ice
    From what I’ve tasted of desire
    I hold with those who favor (fire) INFLATION
    But if it had to (perish) REFINANCE twice,
    I think I know enough of (hate) ZIRP RATES
    To say that for destruction (ice) NO BID
    Is also great
    And would suffice.”

    Marty Whitman now gets Robert Frost.

  6. Lambert strether

    Terrific post, in both senses of the word. Too bad distressed debt doesn’t have the cachet of distressed jeans…..

    1. ambrit

      Well… One may not have the ‘cachet’ of the other, but, when each experiences ‘malfunctions,’ both will leave the wearer “bare-a—d.”

    2. craazyman

      It does if the price is right!

      Knowing when is the hard part.

      How many time since 2009 have we seen this movie? It”s getting to be like those Mars pics from NASA that people put on the internet and they point to a sharp rock and they say “There’s a pyramid on Mars!” A few months later there’s another picture and somebody sees a “glass dome”. Last week there was a UFO in a picture from Mars. It was on the internet! i saw it myself. There was a speck in the sky that wasn’t there in the frame before and the frame after. Maybe it was only a bird. hahahahhahah. (Get it, that’s a joke. “only a bird” on Mars would be big news).

      Is this high yield thing a pyramid (well, we know it is but anyway . . . back to the metaphors), a glass dome or a bird? Or is this THE ASTEROID WE’VE ALL BEEN WAITING FOR ALL THESE YEARS! That sounds like a moviie by Cecil B. DeMille, with a cast of thousands.

      The only thing you can do is talk about it. and if you do, hopefully somebody will pay you for it — maybe even by the word. Typing is easy! LOL

      1. craazyboy

        All those junk companies could just declare bankruptcy and start over. That’s the way it’s supposed to work. Just ask The Donald. Then it would be like that movie where Bruce Willis saved the earth from an asteroid strike. ‘Course there was only one asteroid in that movie. Instead, we have World War Z with zombies all over the place!

        But maybe JYell will buy all the junk bonds, burn them, and then the dollar will crash and we can all get jobs?

        1. craazyman

          I just spent $4000 dollars at Paul Stuart last week. if the 125 pound AbyN is out there, i look hot. just so you know, with the Paul Stuart suit and the Crockett & Jones Westfields,

          i probably should have bought the same stuff on eBay for a few hundred but i was too lazy to measure the suits in the closet and match the numbers with the numbers in the eBay postings. also, it seems like a lot of work.

          it’s like that when you buy junk bonds. you want the yield and you want it now.

          if you have to think too hard about it, that ruins the pleasure of the whole experience.

          1. craazyboy

            Yikes, you must have hit the ten bagger and didn’t tell us. Once AbyN finds out, she’ll be on the next flight to NYC, I’m sure. They don’t serve food on flights anymore, so that will help with the 125lbs, hopefully.

            I don’t think I’d buy clothes on Ebay. I risk it with cheap electronic parts, but those are usually like $4, including free shipping from China. Then I built Dizzy The Quadcopter for the price of a pair of Crockett & Jones Westfield shoes. Priorities, I guess.

          2. Jim Haygood

            There are other modes of living, C-man (though probably not in Manhattan). Comment on a motorcycle review:

            “If not for my wife having other ideas, I could just buy more motorcycles, build a cheap ramp up to the house, and keep them in the living room. I would rather look at motorcycles than furniture anyway.”


  7. Christer Kamb

    MikeNY said;

    “The HY market melted in the Summer of 2008, months before equities noticed what was going on.”

    Not really. HYG market were in a downtrend during summer of 2007, together with the stockmarket. Also in the 2008 summer both markets were in a severe meltdown. This time around the HYG´s started their downtrend from summer 2014 with the 1:st leg down to dec same year. 2:nd leg is now running in which the stockmarket joined. Your right, HYG´s seems to be the canaries here! But, from august this year they seems to go in different directions. Or are they?

    1. MikeNY

      You’re right, it was earlier than Summer 2008, now I think about it.

      What I do remember (and I can’t remember whether it was Spring of 2008 or earlier), was that HY spreads had gapped out at least a couple of hundred bps, and equities were still at or near all-time highs. I remember sitting in a meeting with a couple I-bankers, who chuckled ruefully “equities haven’t a clue”.

      The received wisdom on the Street is that the bond market is smarter than the equity market. And, at last in my career, it was true, at least as far as downturns went.

      1. Jim Haygood

        BofAML’s High Yield spread went from a low of about 2.5 in June 2007 up to 5.9 at the end of 2007 … on its way to an eye-popping 21.8 in Dec 2008.


        Equities haven’t a clue. But neither do the authorities. As a wise old veteran of the Street once told a youthful John Bogle, “Here’s the secret, kid. Nobody knows nothin’!”

      2. harry

        Fun point. I read a piece which argued all he smart guys went into equities in the 90s, and I suspect that’s right. But i guess if you have a question about credit conditions then you are probably best off talking to a bond guy. After all, they have a chance of knowing why they are not buying!

        I wonder whether the time of year is a factor. Pressure on balance sheets and all that. Back to the brake lights analogy.

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