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The Illusion of Liquidity in High Yield and Distressed Debt

Posted by Jack Duval

Dec 22, 2015 7:04:42 AM

This blog post continues our series on the ongoing crisis in high yield and distressed debt bond funds.  For our previous coverage, see: "What's Going on in High Yield and Distressed Debt?" and "The Third Avenue Focused Fund Implosion".

Investment_Liquidity.jpg

Formerly liquid market: Aral Sea, Kazakhstan.

Liquidity

The suspension of redemptions in the Focused Credit Fund (an open-end mutual fund) is remarkable. Although all mutual funds have the right to suspend redemptions, until now, it has been an extremely uncommon occurrence. This may change in the new market reality of reduced bond (and bond fund) liquidity.

The Focused Credit Funds suspension will last until investors are given interests in a liquidating trust that will hold the Fund's assets and sell them over time.  (It is unlikely that a liquid market will develop for interests in the liquidating trust.) This is similar to a Chapter 7 bankruptcy, where a trustee is appointed to liquidate a debtor's assets and use the proceeds to pay the claims of the firm’s creditors.[1]

The travails of the Focused Credit Fund arise out of a liquidity mismatch: the Fund owns highly illiquid investments in a vehicle that provides investors with daily liquidity.

This is something like a liquidity Ponzi: as long as asset prices are rising and money is still coming into the Fund, it will work. If nothing else, redeeming investors can be paid out from new investors. However, as soon as prices start to fall and new money stops coming in, the gig is up.

This is very similar to what happened in the Auction Rate Securities ("ARS") market. As long as there continued to be clients putting money into ARS, they functioned as a liquidity provider for other clients who wanted to sell.   However, as soon as the new money stopped coming in, the broker-dealers that were the liquidity of last resort quickly got their fill of ARS and backed away from the market.

Two significant events have led to less liquidity in fixed income markets since the financial crisis:

  • Federal Reserve open market purchases of trillions of dollars of US Treasury bonds and mortgage backed securities;
  • Wall Street firms have dramatically reduced their inventories, by some counts up to 75 percent.[2]

Chart 1: Primary Dealer Positions[3]

BD_Fixed_Income_Inventory.png 

 The Illusion of Liquidity

Liquidity is, and always has been, mostly an illusion. Ask yourself a simple question: can all the owners of any security, currency, or contract have liquidity at the same time? The answer is obviously "no".

So who gets liquidity?

Certainly sellers who are selling into a rising market get liquidity. Also, sellers when the market is flat. However, the story changes when the market is in decline. The first sellers can get out (albeit at lower prices) but when a lot of sellers hit the market at the same time, buyers can just disappear. In this case the only buyers left are vultures, buyers of last resort who are willing to take securities from forced sellers, at cents on the dollar.

This is the situation the managers of the Focused Credit Fund find themselves in, and is why they have suspended distributions and put the assets in a liquidating trust.

The problem for them is that everyone now knows they are sellers only, and to make matters worse, everyone knows what they own. They are unlikely to see any improvement in the marks on the bonds and loans they have.

Simply put, all distressed and high yield bond funds are now sellers as their client’s submit redemptions. Even clients who would prefer to stay in a fund are motivated to redeem their shares as they get hurt by their panicked co-owners.

In my next post, I will examine the suitability of complex, illiquid, and high risk investments.

__________

Notes:

[1]       U.S. Courts; “Bankruptcy Basics”. Available at http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics. Accessed December 14, 2015.

[2]       SEC Commissioner Daniel M. Gallagher. Speech delivered on March 10, 2015; “A Watched Pot Never Boils: the Need for SEC Supervision of Fixed Income Liquidity, Market Structure, and Pension Accounting”. Available at: http://www.sec.gov/news/speech/031015-spch-cdmg.html#_edn11; Accessed December 17, 2015.

[3]       BBVA Research; “Heightened Bond Liquidity Risk is the New Normal”; September 3, 2015. Available at: https://www.bbvaresearch.com/wp-content/uploads/2015/09/150903_US_EW_NewLiquidityDynamics.pdf; Accessed December 17, 2015.

For information about high yield and distressed debt expert Jack Duval, click here.

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Topics: high yield, Complex Investments, Investment Suitability, Illustion of Liquidity, Third Avenue Focused Credit Fund, Illiquid Investments, distressed debt

The Third Avenue Focused Credit Fund Implosion

Posted by Jack Duval

Dec 21, 2015 8:12:56 AM

This blog post continues our series on the ongoing crisis in high yield and distressed debt bond funds.  For our previous coverage, see: "What's Going on in High Yield and Distressed Debt?".

History, Rhyming

It is said that history does not repeat itself but does rhyme.  If true, we are hearing history rhyming a tune that sounds a lot like the two Bear Stearns hedge CDO hedge funds that went bust on July 16, 2007: the Bear Stearns High-Grade Structured Credit Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Master Fund.[1]

Just like the Fed-induced housing bubble in 2007, the Fed has blown another bubble in high yield debt. The first canary to go happens to be in the energy sector, where master limited partnership structures required continuous refinancing (see our previous posts on this here), a reliance on hydraulic fracturing techniques that resulted in 80 percent well depletions in three years, and years of malinvestment all leading to massive oversupply of oil and gas.

If one chart can tell it all, it is the one below.

Chart 1.  U.S. Oil Rig Count[2]

 12-11-15-oil-rig-chart

Credit Cycle Gears Reversing

Some commentators have tried to make the case that the distress in the high yield debt markets is purely an energy sector phenomenon.  While this may have been true a year ago, this is no longer the case.

Banks and bond buyers that have lost a few fingers in the energy sector will be tightening credit everywhere as they try to reduce risk.  This will lead to much tougher lending conditions (higher rates, more covenants, etc.) for the rest of the high yield/distressed world.  Which in turn will lead to more defaults and more tightening.

This is the credit cycle gears reversing from a virtuous cycle of lower and lower loses and looser credit to a vicious cycle of higher and higher loses and tighter credit.

Keep in mind that this has been occurring before the Federal Reserve's 25 basis point tightening from last week.

Third Avenue Focused Credit Fund

The Focused Credit Fund invested in junk bonds and high risk loans to low quality borrowers.  They also invested in the debt of distressed or bankrupt companies.  Remarkably, the fund would buy 10 percent (or more) of smaller bond offerings, which made exiting those positions difficult.[3]

All of these investments are relatively illiquid even in the best of times, however, in declining markets, they trade by appointment, and with severe markdowns.  As the Focused Credit Fund’s energy and other bets went bad, this illiquidity became an albatross that drug the fund further down as redemptions increased.

As of April 2015, $400M of the Focused Credit Fund was invested in Level 3 assets, those with no quoted prices and no observable inputs that could be modeled. (Level 3 assets have values that are essentially made up by a firm's management.  During the financial crisis of 2008-9 these types of assets were referred to as "mark to make believe", when banks carried their mortgage-backed bonds at cost.)

Level 3 assets are deadly in credit cycle downturns.  For example, Bear Stearns was carrying more than $28B in Level 3 assets at the end of 2007.[4]  The same was (and is) true of the Focused Credit Fund’s holdings.  Once you have to get out of Level 3 assets, you can’t.

TABLE 1: Level 3 Assets owned by the Third Avenue Focused Credit Fund[5] 

Level 3: Significant Unobservable Inputs 4/30/15  
Investments in Securities:    
Common Stocks & Warrants:  
Consumer Products  
Energy 46,622,165  
Financial Insurance  
Manufacturing 1,737,318  
Services 602,563  
Transportation Services 3,767,928  
U.S. Real Estate Operating Companies  
Limited Partnerships:  
Insurance & Reinsurance  
Convertible Preferred Stocks:  
Transportation Services 13,035,278  
Preferred Stocks:  
Energy 3,120,358  
Financials 18,646,543  
Non-U.S. Real Estate Operating Companies  
Corporate Bonds & Notes 138,366,650  
Term Loans 142,059,322  
Claims 6,474,869  
Private Equities:  
Automotive 11,250,000  
Chemicals 9,965,778  
Consumer Products 3,952,674  
Energy 1,043,306  
U.S. Real Estate Operating Companies  
Total 400,644,752  
   
Despite all the illiquid and distressed holdings, the Third Avenue Focused Credit Fund underperformed the Barclays Capital High Yield Index from inception.

Chart 2: Third Avenue Focused Credit Fund Total Return[6] 

Fund_TR_Comparison

Lehman Brothers SIPA Claims

One of the most exotic flowers in the Focused Credit Fund’s junk bond hothouse was the Lehman Brothers SIPA claims, which were among the top 10 holdings of the fund (representing 4.8% of fund assets).  The SIPA claims were brought to market by the bankruptcy Trustee for Lehman in Dutch auctions at slightly less than 25 percent of face value.[7]

Below is a chart of Lehman Brothers Senior Unsecured debt, which is indicative of how the SIPA claims have been trading.

Chart 3: Lehman Brothers Senior Unsecured Debt[8]

 LEH_Sr._Unsec._Debt

In my next post, I will examine what has happened to liquidity in the fixed income markets.

__________

Notes:

[1]       Wikipedia; s.v. “Bear Stearns”.  Available at: https://en.wikipedia.org/wiki/Bear_Stearns.  Accessed December 13, 2015.

[2]       Business Insider; “Oil Rig Count Collapses for 9th Straight Week; Akin Oyedele.  Available at: http://www.businessinsider.com/baker-hughes-rig-count-october-30-2015-10;  Accessed December 14, 2015.

[3]       Bloomberg; “Third Avenue Seen by Top Investors as Fueling more Carnage; John Gittelsohn; December 14, 2015.

[4]       Wikipedia; s.v. “Bear Stearns”.  Available at: https://en.wikipedia.org/wiki/Bear_Stearns;  Accessed December 14, 2015.

[5]       Third Avenue Focused Credit Fund Form N-CSR, as of April 30, 2015. Available on EDGAR, accessed December 21, 2015.

[6]       Source: Bloomberg.

[7]       Law360. “Lehman To Sell $2.5B More in Unsecured Bankruptcy Claims.  Available at: http://www.law360.com/articles/611360/lehman-to-sell-2-5b-more-in-unsecured-bankruptcy-claims;  Accessed on December 14, 2015.

[8]       Source: Bloomberg.

 

For information about high yield and distressed debt expert Jack Duval, click here.

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Topics: high yield, Senior Loans, Third Avenue Focused Credit Fund, Lehman Brothers Unsecured Debt, Level 3 Assets, distressed debt, Lehman Brothers SIPA Claims

What's Going on in High Yield and Distressed Debt?

Posted by Jack Duval

Dec 18, 2015 8:05:00 AM

This is the first in a series of blog posts on the ongoing collapse in high yield and distressed debt bond funds.  Securities litigators should take note, as the companies and funds mentioned are likely to be the source of investor lawsuits.

High Yield and Distressed Debt, Now Offering:

Third_Avenue_Focused_Credit_Fund_-_Everyday_Low_Prices

The Liquidation of the Rentiers

In The General Theory, Keynes wrote about the euthanasia of the rentier (rentiers being people who lived off of the interest from their investments). He was contemplating a situation where capital was so abundant that the rate of interest would decline to a level that the rentiers could not survive off of the interest received from the bonds they owned.

Rentiers were held in low regard because they did not derive their income from labor or from capital investment.  They were viewed as parasites that lived off their accumulated wealth, instead of investing in ventures that would create employment.

Today's rentiers are retired baby boomers who have saved a nest egg for retirement.  A far cry from a Keynesian parasite.

However, modern day retirees have faced a euthanasia nonetheless. In a wicked irony, capital has become abundant because the Federal Reserve has lowered interest rates to effectively zero and purchased trillions of dollars of Treasuries and mortgage-backed securities.  (Ironic because Keynes believed the government should serve as demand of last resort, but in this case the government turned into the euthanasiaist.)  This has reduced the need for retiree's savings, and commensurately, the interest to be earned on their investments.

To understand exactly how far this has gone, one only needs to review the Federal Reserve Quarterly Report on Balance Sheet Developments.  I have extracted a table from the most recent report, below.

Table 1: Federal Reserve Balance Sheet Data[1]

Domestic SOMA securities holdings

Billions of dollars

 

Security type

Total par value as of October 28,

2015

Total par value as of July 29,

2015

U.S. Treasury bills

0

0

U.S. Treasury notes and bonds, nominal

2,347

2,347

U.S. Treasury floating rate notes

*

*

U.S. Treasury notes and bonds, inflation-indexed1

115

115

Federal agency debt securities2

34

35

MBS3

1,744

1,735

Total SOMA securities holdings

4,240

4,231

Note: Unaudited. Components may not sum to total because of rounding. Does not include investments denominated in foreign currencies or unsettled transactions.

* Less than $500 million.

1    Includes inflation compensation.

2   Direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

3   Guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Current face value of the securities, which is the remaining principal balance of the securities.

Seeking to avoid financial euthanasia, many retirees have been forced to seek riskier and riskier investments to generate the income they need to live. While they may have avoided euthanasia, it is less likely they will avoid liquidation.

Indeed, the liquidation phase has just begun.

The Hunt For Yield

As the Federal Reserve has euthanized retirees they have been forced to reach for yield.  Two of the most popular investment destinations have been master limited partnerships (“MLPs”) in the energy sector and high yield/distressed debt funds.  The MLPs were entirely energy plays and the high yield/distressed debt funds were heavily exposed to energy.

Both of them have blown up and are now in a classic Minskian debt deflation.  This will only resolve itself after many waves of asset (and debt) liquidation.

Distressed Debt Funds in Distress

Many fund and other firms exposed to high yield and distressed debt have announced their own distress in the past week. Some of those include:

  • Third Avenue Focused Credit Fund (“Focused Credit”) suspended distributions and announced a plan to put its assets into a "liquidation trust" and give interests in the trust to its shareholders in lieu of cash.[2]
  • Stone Lion Capital Partners L.P., a distressed debt hedge fund also suspended redemptions.[3]
  • Lucidus Capital Partners, announced that it had received significant redemptions in October and has wound down its high yield debt funds.[4]
  • Fixed Income house Jefferies an 83 percent decline in Fixed Income Revenue. The 4th Quarter Report stated:  “Almost all of our Fixed Income credit businesses were impacted by… the collapse in the global energy markets (where we have long been an active adviser, capital raiser and trader), reduced originations in leveraged finance and meaningfully reduced liquidity.”[5]

To get an idea of the capital destruction going on in energy, the charts below are instructive.

Chart 1: Chesapeake Energy 5 ¾’s of 23[6]

 Chesapeak_Energy_Bond_Chart

Chart 2: Kinder Morgan, Inc. Equity Common Stock[7]

 Kinder_Morgan_Stock_Chart

The pain is also spreading to leveraged loans, as seen in the PowerShares Senior Loan ETF chart below.

Chart 3: PowerShares Senior Loan ETF[8]

 PowerShares_Bank_Loan_ETF

In my next post, I will examine what has happened in the energy sector and its impact on the Third Avenue Focused Credit Fund and others.

__________

Notes:

[1]       Quarterly Report on Federal Reserve Balance Sheet Developments; November 2015. Available at: http://www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201511.pdf.  Accessed December 13, 2015.

[2]       Third Avenue Funds Focused Credit Fund Shareholder Letter. December 9, 2015. Available at: http://thirdave.com/wp-content/uploads/2015/12/FCF-Shareholder-Letter-12-2015.pdf.  Accessed December 13, 2015.

[3]       The Wall Street Journal.  “Stone Lion Capital Partners Suspends Redemptions in Credit Hedge Funds. Rob Copeland.  Available at: http://www.wsj.com/articles/stone-lion-capital-partners-suspends-redemptions-in-its-oldest-fund-1449870782.  Accessed December 13, 2015.

[4]       Bloomberg; “Lucidus Has Liquidated $900 Million Credit Funds, Plans to Shut”; Christine Harper; December 14, 2015.

[5]       Jefferies Group LLP Fourth Quarter Financial Results; December 15, 2015. Available at: http://investor-relations.jefferies.com/Cache/1001205242.PDF?Y=&O=PDF&D=&fid=1001205242&T=&iid=102756;  Accessed December 16t, 2015.

[6]       Source: Bloomberg. December 15, 2015.

[7]       Source: Bloomberg. December 15, 2015.

[8]       Source: Bloomberg.  December 15, 2015.

 

For information about high yield and distressed debt expert Jack Duval, click here.

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Topics: high yield, Chesapeake Energy, Stone Lion Capital Partners, Jefferies Group, Senior Loans, Third Avenue Focused Credit Fund, Kinder Morgan, Lucidus Capital Partners, distressed debt

The Yield Bubble - China Edition

Posted by Jack Duval

Mar 29, 2013 4:05:53 AM

Yields on Chinese junk bonds have fallen by 30-40 percent over the past two years, as the hunt for yield goes global.  (NYT)  If "Chinese High Yield Debt" doesn't put the fear of God in you, read this:

Chinese junk bonds also have a unique structure, which could leave investors vulnerable.  Mainland China’s domestic bond market remains largely off limits to foreign buyers. So most investors buy offshore Chinese bonds, which are issued through holding companies headquartered in places like the Cayman Islands.  The bonds tend not to be backed by the actual businesses and underlying assets in mainland China. That means foreign bondholders may have little legal recourse if a company defaults on its debt, especially if local banks or other Chinese creditors make claims.

Investment advisors should be checking any high yield funds they have for China exposure, as this will surely end badly.
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Topics: investments, high yield, yield bubble, fixed income, China, debt

High Yield Debt Stats Flashing Sell Signal

Posted by Jack Duval

Nov 14, 2012 3:11:11 AM

New issue high yield bond issuance is a record highs, while non-investment grade yields are at record lows, Soberlook reports.  (Soberlook) This can only end badly.

 

 

 

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Topics: bubble, Soberlook, investments, bonds, high yield

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