Canary in a Coal Mine?
This blog post is an excerpt from the December 11th edition of OAM's Taking Stock Newsletter.
There was a news item that came out yesterday that I don't think is getting the attention it deserves. Third Avenue Management announced that it has blocked investors from getting their money back from their Focused Credit Fund, citing difficult trading conditions for its securities.
It's one thing for a hedge fund to take this kind of action. After all, if you're investing in what is essentially a limited partnership with an opaque structure, liberal use of leverage, and limited redemption periods you have a fairly good idea that it may be risky. A mutual fund on the other hand, is a highly regulated security that is primarily an investment vehicle for the retail investor.
So what happened? Well, we've been talking all year about the declining liquidity in the bond market as well as the widening of spreads (the amount of additional yield over a comparable maturity "risk free" treasury bond) on lower quality paper as being a sign that investors are shunning risk. With redemption's coming in at a faster rate than Third Avenue could find buyers for the bonds they owned, they had no choice but to take this action to preserve any value at all.
There are many causes to the lack of liquidity in bonds, but two of the main drivers are the amount of bonds outstanding, and the number of dealers in the market trading them. Yet another unintended consequence of central bankers zero interest policy is that corporations saw an opportunity and ran with it. Over $1 trillion in investment grade corporate bonds have been issued in each of the past three years (as per Oppenheimer). Much of that has been used on stock buybacks, paying dividends to shareholders, and fueling the M&A boom.
At the same time, the Dodd-Frank Act, intended to make banks safer after the financial crisis by not allowing them to participate in proprietary trading, has had negative consequences for the bond market. Historically, banks have been the biggest players. When I started at Kidder Peabody in the late 80's, the bond trading room was the size of half a football field staffed with 100's of professionals. And there were 45 other similar dealers, mostly banks, in the market. Now, there are 24 of these primary dealers operating on a much smaller scale. As recently as 2007, dealers had a combined bond inventory of over $9 trillion on hand. Now it's less than $1.5 trillion.
The upshot to all this, the canary in a coal mine, is that the doorway is getting narrow. If the Fed raises rates next week and a lot of sellers materialize, the effect on the market could be larger than in the past. And what effects interest rates will permeate through all markets.
The caveat is that it could be a one-off event. The bonds they were investing in were the lowest quality. Companies in or near bankruptcy. It is such a small niche that when yield starved investors started to put in more money than they could safely invest they should have closed the fund. If that's the case, then I'll go quietly, but not take my eye off bonds.