Do you remember the scene from It’s A Wonderful Life—only the best holiday movie ever—when George and Mary Bailey are cruising out of Bedford Falls on their well-earned honeymoon, only to notice a literal run on the banks (including the Bailey Savings and Loan, which George reluctantly operates)?
Well, as Mark Twain is attributed as having said, “History doesn’t repeat itself, but it does rhyme.” We saw, for example, a run on virtual cash in 2008 when the very first money market fund “broke the buck.” And while you might not have noticed it yet, because it just reached front-page status yesterday, there appears to be a liquidity crisis of smaller proportions playing out right now in the high-yield “junk” bond market.
It is not my aim to spread fear, but rather to spread knowledge in the hope that being informed about what is really happening in the bond markets will ultimately reduce your anxiety. As a friend recently reminded me, “Forewarned is forearmed.”
What happened?
Multiple hedge funds and mutual funds have shocked investors by limiting, or even eliminating, their ability to take withdrawals from their funds. Here are three good articles to bring you up to speed. (Please note that The Wall Street Journal articles may require a log-in to read the entire piece.):
Why did this happen?
You need not look further than the fictional Bailey Savings and Loan crisis to imagine what happened. People lost confidence in their ability to retrieve their investment—in this present case, in junk bonds—and asked for their money back. As more people got scared, the pace at which junk bonds were being sold started moving the price of those securities lower, faster. This created a cycle of fear between investors and fund managers that resulted in those managers halting liquidations. And in this case, unfortunately, the silver-tongued George Bailey wasn’t there to talk everyone off of the ledge.
What could happen now?
Over the weekend, my colleague, The BAM Alliance’s Director of Research, Larry Swedroe, said, “This could lead to the proverbial ‘run on the bank’ as any investors holding less liquid assets, like junk bonds, high-yield bonds, etc., could decide discretion is the better part of valor and all try to get out at the same time.”
That being said, hunkering down for another financial crisis certainly seems premature. Jared Kizer, the firm’s Chief Investment Officer, added, “We don’t see much spillover yet [into the broader markets and economy] because of the size of the high-yield market compared to the private mortgage-backed securities market in 2008, and it’s not apparent that there’s anywhere near the level of leverage in play now as compared to 2008.”
Could this contagion spread beyond the junk bond market?
Yes, Kizer suggests that the liquidity crisis in junk bonds could spread to corporate bonds. And Swedroe does add that because the energy sector is the high-yield market’s biggest buyer—and energy prices continue their precipitous drop—we could see: 1) below-estimate earnings for some big S&P 500 companies, 2) emerging market ripples, especially in resource-rich countries like Russia and Venezuela, 3) all credit spreads widening, and 4) margin calls in the leveraged loan market.
The confluence of all these factors, none of them good, could lead to a flight to securities that are deemed higher quality—like U.S. Treasuries. If the fear gets intense enough, it could even lead to the Fed forestalling its well-publicized plans to raise interest rates.
What should you do?
If, and only if, you have allocations to high-yield bonds, you may want to consider alternative arrangements. Situations like these are precisely why you might consider investing only in the highest quality bonds and staying away from junk bonds and even corporate bonds. These asset classes are regularly subjected to higher levels of risk without a satisfactorily proportionate opportunity for reward.
We all know that stocks are volatile—a fact proven nearly every year (including this one)—but we endure this volatility because the evidence shows that we can expect a higher rate of return (over time) in exchange for occasionally unsettled stomachs.
We invest in the stock market to make money, but we invest in bonds to stabilize portfolios and help us stay invested in stocks during those inevitable volatile times. Consider risking abject boredom in your fixed income allocations, precisely to avoid instances like these when seemingly safe bonds (and the funds that hold them) go rogue.
It is certainly possible that this somewhat isolated crisis will remain that way, although it seems to have already spooked the broader market a bit. But I don’t believe that a wise course of action is to try to time the market (guessing if and when the market will decline, and then subsequently attempting to determine its next rise).
I appreciated the honesty of Thomas Lapointe, lead portfolio manager of the recently halted Third Avenue’s Focused Credit junk bond fund, when he confessed that “the magnitude and scope of managing this fund over the past year has been a humbling experience.” Unfortunately, Lapointe is learning the hard way a lesson that virtually all investors are destined to experience—that we must be smart enough to know we can’t outsmart the market.
This commentary originally appeared December 15 on Forbes.com
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