The high-yield or junk-bond market has seen so much selling in the past week that some are fearing a return to the credit crunch days that followed the collapse of Lehman Brothers. In one week, $3.3 billion was taken out of high-yield mutual funds and exchange traded funds.
William Porter, managing director in credit research at Credit Suisse, wrote, “There is a theme at present that credit is leading other markets, and is predicting ‘recession.’ We are worried…”
The iShares iBoxx High Yield Bond ETF, considered a key barometer of this market, is trading below the lows hit after the Lehman Brothers collapse in September 2008.
This rush to abandon high-yield bonds will put pressure on the corporate bond market and could make it more expensive for retailers to borrow money next year. Some companies are already up to their necks in debt and with the potential for a less than stellar holiday, may find they are standing at the edge of a financial cliff.
The alarm bells began ringing last week when mutual fund Third Avenue Focused Credit Fund said it was shutting down, and then froze investor redemptions. The fund told investors they may have to wait weeks or months to get their money back — or at least some part of it.
High-yield bonds, or junk bonds, are bonds issued by companies whose credit rating is below investment grade and when the price of the bond falls, its yield goes up. Many retailers and fashion companies use this market as a way to raise money for expansion or acquisitions. It’s less expensive than a bank and they can take longer to pay it back. A good retailer that looks like it’ll pay the bondholders back gets a higher rating than a risky retailer. For example, a stable company like Macy’s is rated BBB+ by Standard & Poor’s making it a High Yield issuer, while a struggling retailer like J. Crew gets a B- rating and has a negative outlook and so the debt is called a junk bond.
Retailers rely heavily on the junk-bond market for money to keep their companies going when they hit rough patches. If the holiday season doesn’t pay off and stores are forced to mark down unsold inventory, the cost to borrow that money could be extremely high. Plus, even if a retailer tries to sell a bond to raise money, there might not be any buyers for it.
The carnage in the junk bond markets started as energy companies and mining companies saw their bond prices plunge. The selling didn’t stop with those groups. The Third Avenue Fund held some retail bonds like Claire’s Stores. Claire’s Stores’ 6.125 bonds due 2020 are trading at roughly 50 cents on the dollar, such that the yield on the bond is closer to 25 percent.
Junk bond hedge fund Stone Lion Capital also suspended redemptions while Lioneye Capital is closing at the end of December. Avenue Capital Group’s fund Avenue Credit Strategies Fund was also hit hard by redemptions from high-yield funds and saw the size of the fund cut from $2 billion to $884 million. It was run by the same manager who launched the Third Avenue Focused Credit Fund, sparking the fear that pushed its billionaire manager Marc Lasry to step up and back the fund.
“What could happen is that mutual funds when they have outflows, will try to sell what they can. If they try to sell energy assets and don’t find buyers, they could turn to consumer discretionary,” said J.R. Rieger, managing director of fixed income indices at S&P Dow Jones Indices. “Instead of selling energy-related debt, they sell Macy’s or Nordstrom and that will create more selling than buying and changes the supply-demand equation.”
While Macy’s stock is down 45 percent year-to-date, its high-yield bonds are selling at a premium and the company’s outlook is rated as stable.
Rieger warned that if retail investors get worried, they will trigger heavy selling in the high-yield mutual funds. “Retail sentiment is so powerful it could force outflows and the portfolio managers have to sell something to raise cash and pay redemptions. They’ll be looking for bonds they can sell in the market,” he said.
Retailers need buyers for their debt. For example, J. Crew has a debt to capital ratio of 187 percent. To put that in perspective, VF Corp.’s debt to capital ratio is 40 percent, while American Apparel’s is 200 percent. Given the ratio, J. Crew can ill afford to see its debt costs rise. The retailer’s debt can be found under Chinos Intermediate Holdings where a 2019 bond with a 7.75 coupon is selling at only 25 cents on the dollar. If an investor took a risk on this bond, the yield would be roughly 65 percent.
“It’s a challenge for J. Crew,” said Citigroup analyst Jenna Giannelli. “Investors may only feel comfortable with higher quality issuers. Those with BB or lower ratings could find they have no access to financial markets.”
Gianelli mentioned other companies that are in the same predicament, including Gymboree, Nine West, Bon-Ton, American Apparel and Quiksilver. She made it clear that these retailers are still able to fund their debt.
Men’s Wearhouse is another example of how quickly debt can fall out of favor with fund managers. A 7 percent bond that matures in 2022 was selling above par at 108 in June. It is now priced near 69, making the yield closer to 14 percent. Fortunately, Men’s Wearhouse has its debt in check with only a 62 percent debt to capital ratio.
Investors can also buy credit default swaps, an instrument meant to protect a bond buyer against nonpayment. These instruments are viewed as the canary in the coal mine. If bond buyers begin to get nervous, they start buying insurance in the form of credit default swaps or CDS. The five-year CDS for J.C. Penney has jumped from a bid near 600 during the summer to last week’s bid of 935. J.C. Penney’s longer-term debt, like a bond due in 2037, is selling near 59 with a potential yield of 11 percent, almost double the real coupon of 6.375 percent.
Neiman Marcus has seen its five-year CDS widen by 45 percent over the past week and are 92 percent wider since the start of December. Fitch Solutions director Diana Allmendinger said, “Disappointing quarterly results released this past Monday appear to have added to market concerns over Neiman’s credit prospects.” She noted that credit protection on Neiman Marcus debt is now pricing deeper into speculative grade.
“The big question is, does it spill over to the banks that leant them all this money,” said David Nelson, chief strategist at Belpointe Asset Management. “Where’s the liquidity? Third Avenue shutting down might be just the tip of the iceberg.”