Why is the high yield bond market struggling with liquidity concerns?
Blog from Jean M. Rosenbaum, CFA, Portfolio Manager
Hotaling Investment Management, LLC
The high yield market has been in the news recently due in part to its lack of liquidity. The increasingly poor liquidity situation was brought to the forefront by Third Avenue’s decision to halt redemptions in its Focused Credit Fund mutual fund. (Open end mutual funds provide daily liquidity to investors so the inability to withdraw funds has caused concern among investors in the asset class.) The liquidity concerns come from 3 primary sources – the fund itself, the energy sector and the regulatory environment.
The first problem lies with the fund itself. The fund invested in assets which were illiquid. Providing daily liquidity from such an asset base is possible only if the fund is growing. Once the fund stopped growing, the inability to sell assets impaired its ability to provide liquidity.
The second problem is the financial stress in the energy sector. The energy sector has become a larger part of the high yield market in recent years. Investors were happy to fund these cash flow negative companies in a high and rising commodity price market. Once the oil and gas prices began to weaken, investors became increasingly concerned about the ability of these companies to service their debt. Default rates, which are at cyclical lows, are likely to rise.
The third problem is related to the post-Financial Crisis regulatory environment. New regulations are changing the way bonds are traded. The bond market is an “over-the-counter” market. Unlike stocks, bonds are not on an exchange. Bond trading had been facilitated by an investment bank’s use of their own capital to create market liquidity by buying and selling securities, engaging in what is called proprietary trading. Following the financial crisis, new regulations limit the ability of investment banks to engage in proprietary trading, thus limiting their ability to create a liquid bond market. The limitation on proprietary trading, while put in place to safeguard the banking system by limiting the size of the balance sheets, has had the unintended consequence of severely limiting bond market liquidity.
Over time, market liquidity will return as the challenges of moving an over-the-counter market to an exchange are solved. The problem is most acute for active bond traders and for other investors that require liquidity and need to sell their bonds. Recent market events could be the catalyst to force market participants to solve the trading gridlock.
Image by By Svilen.milev