“The junk bond market was a keg of dynamite that sooner or later will blow up”
— Carl Icahn, on CNBC
On Dec. 12, Carl Icahn warned that a lack of liquidity could cause the high-yield market — otherwise known as the junk-bond market — to implode and contribute to a broad market crisis. While other noted investment strategists feel Icahn could be overstating the problem, he deserves attention, given that he amassed much of his fortune, estimated at over $21 billion, using junk bonds.
The day before Icahn’s statement on CNBC, The Third Avenue Focused Credit Fund — a mutual fund — closed and prevented redemptions. Unlike hedge funds that have prevented investors from taking out their money, mutual funds have traditionally not taken this step. Because Third Avenue had lost over 27 percent for the year through Dec 9 and had suffered from over $1.3 billion of outflows, its management was forced to take extraordinary measures that generated much unflattering publicity.
Raul Elizalde, president and chief investment officer of Sarasota-based Path Financial, identified three prominent investment failures in his article “Junk Bond Failures May be the Tip of the Iceberg”:
• Third Avenue Management blocked $790 million of redemptions.
• Stone Lion capital blocked $400 million of redemptions.
• Lucidus Partners liquidated its high-yield-oriented fund.
Elizalde noted, “it’s too soon to say the worst is over for investors. . . . It took over a year for the earliest signs of serious problems in the mortgage bond market to metastasize into the collapse of Lehman Brothers and a full-blown financial crisis.”
On Wednesday, when the Federal Reserve finally made its much-anticipated rate increase, Janet Yellen, the Fed chairwoman, sought to reassure investors by suggesting that the Third Avenue fund’s problems were far from pervasive: “It had many concentrated positions and especially risky and illiquid bonds.”
Gary Cohn, president of Goldman Sachs, echoed Yellen in a note to clients: Cohen wrote: “The Third Avenue situation is unique. They owned really low-credit-rated products to the typical high-yield fund. No one thinks that the collapse of Third Avenue is going to contaminate the world.”
Cohen’s rationale: Third Avenue’s failure did not put any lender in peril, in contrast to the collapse of Lehman Brothers and the ensuing crisis throughout Wall Street.
Energy and mining firms, whose troubles have been exacerbated by low commodity prices, account for about 20 percent of the junk-bond market.
Mark Wiedman, global head of the iShares exchange-traded fund, the world’s largest family of ETFs, criticized Third Avenue management for holding so many illiquid assets while offering daily liquidity.
Unlike mutual funds, ETFs do not need to sell underlying fund positions to meet shareholder redemptions. Instead, the stock price of ETFs declines if sellers outnumber buyers.
Howard Marks, co-chairman of Oaktree Capital Management, the world’s biggest distressed-debt investor, has previously warned about excesses in the high-yield market. Marks feels, however, that the problems of Third Avenue do not provide the ingredients for a market meltdown of the whole high-yield asset class.
“I’d be very surprised if it (Third Avenue) leads to any kind of cataclysm,” he wrote.
While it is premature to evaluate Icahn’s prediction that we face a broad financial crisis, his warning should be a wake-up call.
The decision by the Federal Reserve to raise rates begins the long process of returning normalcy to our fixed-income markets.
The prevalence for over seven years of abnormally low interest rates encouraged investors to reach for yield by acquiring high-risk bonds. Alternatively, many of us own a higher percentage of equities than appropriate for our age group because the nominal dividend yield on these stocks exceeds that of the 10-year Treasury note.
As a former managing director of Morgan Stanley and chairman of its Fixed Income New Product Group, I urge all of us to honestly assess the percentage of our nest egg that is truly risk free.
Remember: It is not how much you can make, it is how much you can afford to lose.
Originally published in the Sarasota Herald-Tribune
