The junk-bond market has something to really fear: fear itself.
Investors are rushing out of junk bonds, spooked by last week's closure of a mutual fund focused on some of the lowest-quality, highest-yielding bonds. The shutdown comes on top of fears that a spike in bond defaults is coming, and it's led investors to rush for the exits in a corner of the market that generally doesn't handle such things well.
The price drops are hitting many investors who are new to junk bonds and have little experience with the notoriously volatile market. Since the Federal Reserve slashed interest rates to a record low in 2008, investors have been creeping into ever-riskier options in search of more income. They've been attracted to junk bonds, also known as high yield, because they pay higher interest rates than high-quality bonds. The downside is that they're issued by companies more likely to default, socking investors with losses.
In just two days, the central bank is widely expected to finally raise rates above their emergency low levels. The policy has helped avert a deeper downturn following the financial crisis, but critics say it's also spread hidden risks throughout the financial system by making investors cavalier.
"Investors took more and more risk without even knowing it," said George Cipolloni, a co-manager of the Berwyn Income fund.
As investors have demanded their money back from junk-bond funds in recent days, managers are being forced to sell bonds to raise cash. And with buyers scarce for the lowest-quality bonds, managers are selling higher-quality ones.
The forced selling is pushing prices lower across the junk-bond market, not just for the kinds that led to last week's fund closure. That's making investors even more scared and creating a vicious cycle of fear and selling. It led the largest junk-bond mutual fund to a 1.2 percent loss on Friday, its biggest in four years. The biggest junk-bond exchange-traded fund was down 1.4 percent Monday after dropping 2 percent Friday.
The price drops have been so sharp and indiscriminate that some analysts see a chance to buy some types of junk bonds at attractive prices. But that doesn't mean they expect the declines to end soon.
"It's going to affect the entire market," said Jim Kochan, chief fixed-income strategist at Wells Fargo Advantage Funds. "It would be overly optimistic to say that this is finished."
If the junk-bond swoon gets worse, it could eventually hit higher-rated bonds and other markets. One of the big drivers for the stock market — stock buybacks — could be in for a slowdown, for example.
The Third Avenue Focused Credit fund told shareholders last week that it was closing, in part because many shareholders were asking for their money back.
David Barse, who stepped down Monday as CEO of Third Avenue Management, told investors last week that the fund may have been able to make gains on its investments if given enough time.
But the fund saw that if it wanted to raise cash quickly, it would have to sell holdings at steep discounts, and that would "unfairly disadvantage the remaining shareholders."
By closing the fund, it could take more time and net the highest prices possible. But, in an unusual move for mutual funds, investors may also have to wait a year or more to get most of their cash back.
THE SCARIEST SECTOR
The default rate is still relatively low for junk bonds, but the pace is picking up around the world. Standard & Poor's has counted just over 100 defaults so far this year, the highest number since the end of the Great Recession.
Much of the pain is focused on companies that produce oil and metals, whose prices have plummeted. A barrel of oil is at its lowest price since 2009, which makes it tough for energy producers to make enough money to repay their debt. That's caused investors to flee the sector on worries of a spike in defaults.
Junk bonds of energy companies have lost 19 percent this year on average, much worse than the average loss of 5 percent for the broad junk-bond market.
TRADERS CAN'T FIND PARTNERS
Similar junk-bond selloffs in recent history were followed quickly by rebounds, like the selloffs in 2011 over fears about Europe's debt crisis, in 2013 over fears about rising interest rates, and late last year as oil tumbled.
But Berwyn's Cipolloni thinks this time is different, in part because of how far and wide the fear has rippled out among investors, from junk bonds in one industry to junk bonds in others.
"It started in energy and materials, and now it's spread to retail and health care," Cipolloni said. "It will become more pervasive."
He cited investment-grade bonds issued by Community Health Systems due in 2022, which are currently trading at $92.57, compared with $106 in early October, a big move down for a bond.
Part of the problem is that is become more difficult for bond investors to find trading partners, making the market less flexible, or, as traders say, less liquid.
Mutual funds and ETFs are designed to be relatively liquid investments, so investors can sell and exchange their investment for cash. Critics say that mixing such liquid investments with an illiquid junk-bond market can cause these vicious cycles.
Marilyn Cohen, founder of bond manager Envision Capital, says the market is particularly vulnerable now because of what companies did with the trillions of dollars they raised from bonds.
Instead of expanding their business, which might have made it easier to pay off what they owe, many companies used the cash to buy back their own shares or hand out fat dividends to their shareholders.
Corporations have been the biggest buyers of stocks for years, helping to lift the market. If companies find it tougher to borrow, even those with strong credit ratings, the torrid pace of stock buybacks could slow.
"We're getting our comeuppance, and it's well warranted," Cohen said. "It all got overdone."
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