The credit market warning klaxons are blaring – investors beware

If you were around during the financial crisis, you might remember that fund closures became one of the canaries in the coal mine.

Various funds failed in the run-up to the crisis, as bad bets on risky assets went wrong and the economic backdrop became steadily less forgiving.

Why am I reminding you of this?

Because we’ve just seen the biggest mutual fund failure in the US since 2008…

The first domino to topple?

Last week, Third Avenue Management shut down its $788m ‘Focused Credit Fund’ – a fund investing in corporate bonds.

The fund’s value had dropped by 27% in 2015. The key problem, notes Robin Wigglesworth in the FT this morning, is that the fund had run out of money “to pay withdrawing investors without having to dump hard-to-trade bonds at fire-sale prices”.

The fund, apparently, is unusual in offering investors the ability to withdraw their money at any time they want to, even while dealing in more obscure parts of the corporate bond market.

So it could just be the inevitable victim of a flawed business model. If you invest in illiquid assets (ones that are hard to trade) but also allow people to take their money home whenever they like, then you’re just asking for trouble. You don’t need an actual crisis to materialise – you just need people to start getting worried that one might appear.

However, it’s indicative of wider problems in the sector. “Junk bonds are heading for their first annual loss since the financial crisis”, says Wigglesworth. Hedge funds investing in the sector have lost 12.5% from the 2014 peak.

Of course, hedge funds doing badly is hardly news, as my colleague Merryn pointed out recently. But that’s the third-biggest drop for the sector since 1990. And it’s “only significantly exceeded” by the 27% slide seen during the financial crisis.

Much of the problem is down to stress in the energy sector. As the oil price has fallen, more and more energy companies have been struggling. Indeed, energy trader John Arnold told CNBC last week that he expects “half of US energy companies to go bankrupt next year if oil prices do not rebound”.

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Some analysts suggest that the focus on energy means the problems are contained. The big problem with this is that if you’re a lender, and one part of your balance sheet is suddenly looking saggy because you gave a load of money to a group of people who are now unexpectedly going bust, what does that do to your behaviour?

Do you relax your credit criteria and focus on lending more money to compensate for the loans that are going bad? Are you hungry to take on even more risk? Or do you hunker down, pull in your horns, and make your lending criteria tougher?

It’s the latter, of course. And that’s when all the other marginal projects that lenders indulged during the boom years start to fall apart too.

The danger is that, so far, equity markets have been apparently immune to all this. That basically makes no sense, because equities are riskier than bonds (they are lower in the pecking order for picking at the bones of a dead company).

As Jesse Felder of the Felder Report told CNBC: “Debt-funded buybacks and mergers have been a massive source of demand for equities in recent years: a turn in the credit cycle has major implications for the broad stock market”.

In short, things could start turning nasty for equity markets too – judging by Friday’s crash, perhaps they have.

What could possibly go wrong?

We can almost always rely on the actions taken to solve the last crisis to plant the seeds for the next one.

Rampant money printing by central banks created a ‘devil-may-care’ risk-taking attitude among investors. So they piled into whatever was going, without worrying too much about the risk of bankruptcy – after all, the US Federal Reserve had pretty much abolished it.

Meanwhile, new rules imposed to make banks safer have also made bonds more illiquid as a whole.

So you’ve got the Fed encouraging the market to pile into debt and at the same time, new rules making it harder to trade and more prone to crash if anyone panics.

What could possibly go wrong?

We’ll be looking at this in a lot more detail in the next issue of MoneyWeek magazine. If you’re not already a subscriber, get a subscription now.

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