Over the month of December, the market for high-yield bonds (also known as junk bonds) had a mini-meltdown that’s raised some eyebrows.
Junk bonds, which are non-investment grade debt instruments that are issued by companies with poor credit ratings, are both high-risk and high-reward. If the companies don’t default on their payments, the bonds pay a nice premium to the investor. In fact, the risk and return on junk bonds is generally comparable with that of stocks.
However, sometimes these companies can and will default on their debt obligations, and here’s where the risk comes in. This time, it is the energy sector that is the culprit.
When low oil prices hit last year, many fringe oil and gas producers believed that it would be possible to wait out the market for better prices. Some of these companies even issued risky junk bonds to raise capital to sustain operations until better times.
The recent action in oil and commodity markets have made it clear that oil prices could be low for a long time. Now, these fringe shale producers that have been holding on for better times may get a different type of medicine.
Standard & Poor’s recently warned that a stunning 50% of energy junk bonds are “distressed,” meaning they are at risk of default. That’s about a total of $180 billion distressed debt, which is the highest level since the Financial Crisis.
Investors began pulling money out of the credit markets fast. Last week, investors pulled a record $5.1 billion out of mutual funds and ETFs investing in junk bonds. Investment-grade bond and junk bond yields are now at their highest since 2012.
On top of that, several funds announced they would be locking out investors from withdrawing their funds. Third Avenue has blocked investors from retrieving money from its credit fund, Stone Lion suspended redemptions in its credit hedge funds, and Lucidus Capital Partners liquidated its holdings to try and get money back to investors.
What does this mean for ordinary investors?
Jeffrey Gundlach, the “Bond King”, talked about this in his latest presentation for DoubleLine Capital:
I’m sure many people on the call have never seen the Fed raise rates. And I’ve got a simple message for you: It’s a different world when the Fed is raising interest rates. Everybody needs to unwind trades at the same time, and it is a completely different environment for the market.
In 2016 we will be sailing into some uncharted territory.