Last week the stock market responded to some potential rumblings in the high yield market, or so it seems. Apparently some hedge funds are stuck and are having trouble with the illiquidity in the system. Third Avenue announced they are halting redemption requests, likely as they are coming in fast and the firm is having trouble liquidating their holdings to meet redemptions. Even Carl Icahn said the junk market is a time bomb ready to explode. Perfect! I want in!
This is nothing new, especially in the distressed debt arena. High yield/junk debt investing is a very speculative area and unless conditions are just perfect then potential trouble exists. In fact, hedge funds in all groups are always needing to meet redemption requests and if they do not hold adequate levels of cash then positions are sold at fire sale prices. If performance is lousy some fund managers will just give up and return money to investors before this situation occurs.
Yet, this junk debt situation smells more like an opportunity to me rather than a problem. Much of the problems surrounding high yield can be traced to the enormous drop in crude oil. Firms in this sector produce/extract oil and many have issued debt. The price of this debt may have been dropping over the last couple of years as the potential for default increases.
But we have seen crude prices rise and fall over the years. This current cycle down is no surprise as oil production expands, the opposite of what we saw just a few short years ago when demand exceeded supply. Currently, oil supplies are excessive the estimates for demand in 2016 were reduced (just last week). US oil production continues to grow and add to the supply mix, to the dismay of other suppliers like OPEC. Pressure on crude for an extended period may correct the supply, and maybe some companies will fall by the wayside.
In that case, junk debt will price even lower and perhaps we’ll see some defaults. But if I’m a fund manager and see debt prices currently at bargain-basement prices, I’m selectively buying these bonds in names that I believe will be around through the carnage. I would take my chances at buying a basket of bonds that are priced 40% or more below par. Remember, the bondholders get paid before equity holders in the case a company fails.
