By John Mauldin
The fund managers made the right call to liquidate their holdings slowly, getting the best values they could. But that won’t work if the entire fund industry is strained at the same time. This is a structural problem with mutual funds and ETFs. They must redeem their shares on demand, usually in cash (though some reserve the right to do it in-kind). If enough shareholders want out at the same time, this can force them to sell fund assets on short notice.
When the recession hits, we will see junk bonds — and the riskier end of corporate debt generally — go into surplus. There will be more available for sale than investors want to buy. The solution will be prices dropping to a point that attracts buyers. I don’t know where that point is, but it’s a lot lower than now.
But there’s a problem. We talked about that $3 trillion worth of BBB bonds . Any that are downgraded by merely one grade will no longer qualify as “investment grade.” That means many pension funds, insurance funds and other regulated entities by law won’t be able to hold them. They have a very short time to sell them back into the market.
Let’s say Company X issues $100 million of a bond rated BBB by Moody’s or Standard & Poor’s. There is a high likelihood that some will be in regulated pension or insurance funds, and there will be forced-selling at lower prices. This will set a new price for that bond issue. Every mutual fund and ETF that holds those bonds will have to use the lower price when they mark-to-market at the end of the day.
I have seen this happen three times in my career. Yields go from fairly low to 20% or more at what seems like warp speed. If you are in one of those funds, you’re going to see your value drop precipitously. Unless you are a professional or have some systematic trading signal that tells you when to trade, it’s probably best to avoid anything that looks like a high-yield mutual fund or ETF.
More money is going to be lost by more people reaching for yield in this next high-yield debacle than all the theft and fraud combined in the past 50 years.
I can understand the plight of retirees who are struggling to live on today’s meager yields. Those high-yield funds have been so good for so long, it’s easy to forget how disastrous a bear market can be. But it gets worse.
Quick personal story, and I have to be vague about names here. Some bond issues have been bought in their entirety by a small handful of high-yield bond funds. The problem is that the company that issued those bonds has defaulted on them. Not just missed a payment or two, but full default.
Their true value, if the funds tried to sell them, might be 25%-30% of face value if they actually traded, according to the people who told me this. But the funds still value them at the purchase price of $0.95 on the dollar.
How is it they’re still valued much higher? Because the funds haven’t tried to sell them. No transactions mean they can still be “priced” at the last trade, and since there have been no subsequent trades, there is no “mark-to-market” price.
If any of those few funds sold any of those bonds, it would set a “market price” and all would have to mark down the entire holding. So, naturally, they aren’t even trying to avoid taking the hit to their net asset value (NAV).
So here’s my question: How many other junk bond issues are in similar positions?
Note this isn’t just high-yield funds. Lots more “conservative” bond funds try to juice their returns by holding a small slice in high-yield. Regulations let them do this, within limits, but these funds are so huge, the assets add up.
This game could fall apart very quickly. Any event that triggers redemptions could set off an avalanche.
I don’t know what that event would be, but I’m pretty sure one will happen. My own goal is to be a buyer, not a seller, whenever it occurs. For now, that means holding cash and exercising a lot of patience.
If I’m right, the payoff will be a once-in-a-generation chance to buy quality assets at pennies or dimes or quarters on the dollar. I think the next selloff in high-yield bonds is going to offer one of the great opportunities of my lifetime.
In a distressed debt market, when the tide is going out, everything goes down. Some very creditworthy bonds will sell at a fraction of the eventual return. This is what makes for such great opportunities. They only come a few times in your life.
There will be one in your near future.
Since 2001, investors have turned to John Mauldin’s Thoughts from the Frontline to be informed about what’s really going on in the economy. Join hundreds of thousands of readers, and get it free in your inbox every week.