Sell-off in high-yield debt market casting doubt on strength of US economy

NEW YORK (REUTERS) - The sell-off in the bellwether high risk corporate debt market is spreading fears that the US economy is on less sound footing than investors thought.

On Monday (Dec 14), the widely-traded iShares iBoxx $ High Yield Corporate Bond ETF - essentially a basket of junk debt - expanded its losses for the year to 12 per cent. A competitor product, the SPDR Barclays High Yield Bond ETF, expanded its losses for the year to 13.4 per cent.

Seven years after the credit crisis, the recent failure of a handful of funds investing mostly in distressed debt has taken on a mythic quality in the minds of some investors who view debt markets as a leading indicator of problems that could later haunt stocks and the economy.

"Liquidity-supported markets, which is what we have had for a while now, are particularly vulnerable to the possibility of policy mistakes and/or market accidents," said Mr Mohamed El-Erian, chief economic adviser at Allianz SE, speaking of the US Federal Reserve's multi-year policy of holding interest rates low and propping up the bond market with big purchases.

"Investors today are worried about both, given the evolving divergence in monetary policy and the liquidity problems in certain market segments" including the energy-heavy corners of the corporate debt market.

The question for investors in stocks as well as bonds is whether pain in the high-yield market is a sign of much wider economic suffering to come.

Monetary policy in Europe and elsewhere is generally easing while in the United States, the Fed is expected to start a tightening cycle on Wednesday on signs of labour market health.

The benchmark S&P 500 is down just 5 per cent from an all-time closing high, issuance of investment-grade corporate debt remains high and a Fed rate hike would be another vote of confidence in the economy.

Could the Fed and US markets be terribly wrong? Fund managers and analysts who watch high-yield debt believe they could be.

High-yield issuers posted at least US$1.5 billion (S$2.1 billion) in defaults every month for 13 consecutive months, just one month shy of the streak seen at the peak of the credit crisis in 2008 and 2009, according to Fitch Ratings Inc.

The relative gap between the yields required by some corporate debt investors and what they expect for risk-free assets, known as spreads, are as wide as they have been since that period. Coming into Monday's market, the average spread of junk bonds over comparable Treasuries stood at 7.10 percentage points, the widest since June 2012, according to data from the Bank of America Merrill Lynch High Yield Master Index.

In Friday's widespread sell-off, high yield bond spreads widened by the most in a day since August 2011.

"It's now in the realm of possibility that we have a recession in 2016, especially some localised recessions in the Midwest states," said Mr Brian Peery, a portfolio manager at Hennessy Funds. "At a certain point, the benefits of low oil to the consumer gives way to losses in the job market in the oil patch, especially in the Midwest."

Last week, Third Avenue Management LLC said it would block redemptions and liquidate a fund with US$789 million in assets. Stone Lion Capital Partners LP, a manager of US$1.3 billion that specialises in distressed debt, later suspended redemptions in one of its funds. Lucidus Capital Partners also liquidated its portfolio and plans to return the US$900 million it has under management to investors next month, according to a media report.

Beyond the fund failures, liquidity conditions - the ability to easily trade at prevailing prices - are often impaired at this point in the year.

Furthermore, the downward slide in energy prices has been greater than most investors anticipated, putting pressure on markets from US manufacturers to emerging-market commodity exporters, according to Mr Krishna Memani, chief investment officer for OppenheimerFunds.

"The worst risk in the marketplace is effectively slowdown in the US economy because of Fed tightening, the strong dollar and wider credit spreads," said Mr Memani. "There are substantial parts of the US economy that are reeling."