Did a Butterfly Just Flap its Wings in Denmark?
I am not entirely sure, but the decision by a number of plain vanilla investment managers in my home country to increase redemption fees on their high yield funds does raise my eyebrows quite substantially. Last week Sydinvest thus followed Sparinvest in increasing the exit-fees on a number of their high yield bonds, and you don't get a clearer signs of illiquidity. I doesn't, yet, violate my view as expressed in my two previous posts that sector rotation in the latter part of the cycle can still garner significant excess returns, but if this becomes a general tendency, I would run for the hills.
Consider a big diversified HY fund, and the following sequence of events.
1) They try to sell a bond from Energy Turd 1, marked to market at 95, but get it off at 75.
2) The get scared as they begin to sense that liquidity is drying up, and if redemptions continue/accelerate they might not be able to meet cash demands.
3) They impose Hotel California type exit costs in order to share the burden of the illiquidity costs with the investor.
We have heard talk about the Fed, and the regulator, considering exit fees on bond funds, and I am very curious to investigate whether this is actually happening on a larger scale. The Danish example above indicate that it might be, and we should look for this trend, if it is indeed one, to migrate into ETF space as well. If large buy-and-hold investors are still not getting worried, I think we are ok at the margin, but if the likes of Templeton et al. suddenly decided to do a little spring-cleaning in their bond portfolio the liquidity of the market could be stretched to a breaking point.
During the sell-off in October, the big guns were quick to express their desire to buy the dip, but the hole is just getting smaller. The chart in this post by Dealbook on just how concentrated the holdings of some of these issues are is a huge warning sign for me. This also leads me to adjust my strategy (in preparation) for how to ultimately play this. Shorting the equity and debt of the underlying companies and sectors, energy for example, has been a lucrative punt, but the big one has to be heart of the carousel. When the largest bond funds of the world start slugging it out to reduce their bond portfolio sizes, the equity of the likes of BLK, BEN and ALZ could be real juicy plays on the probability of the non-financial corporate debt binge going systemic. Central banks will come to the rescue, eventually, and the next big rounds of QE in the US will likely include corporate bonds, but we are far from such a point. First comes the panic, and it might not come next year, but when the Fed shakes the tree (and I think it will), apples rottening on the vine will be the first to hit the ground.
If the notes above represent a working hypothesis for the sources of the next global financial panic, the portfolio remains broadly constructive. It has benefited nicely from the Santa rally, which arrived right on cue, and to boot, the biggest positions has had some real legs in the past week. Unless the world ends in Greece, this year should be very good indeed. Specifically, the position in Eurozone banks is holding up, just, but is trading poorly, and is starting to represent dead money given the uncertainty (and rising bullishness) for the first quarter. Elsewhere, it is all very much steady as she goes except for the performance of CNA which has been atrocious. Overall, in the next few months, I still think the market is about to show the bears just how effective divergent sector leadership can be in forcing a steady grind higher in global equity indices.