The Junk Bond Canary In The Coal Mine


Did you know we’ve waited longer for a Fed rate hike than a Star Wars movie?  It seems unreal that it has been almost a decade since the Fed raised short term rates.  It’s been so long that it’s worth remembering what consequences a rate hike can bring as many have forgotten or are too young and inexperienced to know.  

Being old myself, I can remember back in 1994 when the Fed raised in the face of rising inflation and the restriction in credit eventually brought on the Asian financial crisis.  There are always unintended consequences to a rate hike.  Who knows what they might be this time, but let’s take a guess.

A rate rise by the Fed signals tighter credit conditions in the economy, a bad thing for businesses reliant on large amounts of debt to fund their operations.  Although most likely this cycle will begin with a very nominal increase, and will just be getting interest rates back to a non-accommodative position, it is accurate to say that borrowing costs will be going up.

In addition, higher rates will make existing bonds with lower rates worth less, as the end value of the security will be less with lower coupons.  Put yourself in a money manager’s position as maybe he has loaded up on long-term bonds in search for yield.  Now, in the face of a cycle of higher rates, those bonds will lose value.

Back to 1994, I remember when investors in so-called ‘safe’ bond funds lost 30% of their principal in a very short period of time once the Fed started raising rates.  You see, it’s not just the first rate increase, it’s the expectation of further rate increases.  Bond funds are especially vulnerable as the investor is never promised to get his principal back.  If you own the underlying security, when it matures, your principal is returned, not so in a fund.  This is what make bond funds so risky, something many fixed-income investors are not aware of.

That is why the failure of several high profile junk bond funds over the last few weeks is very likely heralding more stress in the credit markets and more bond fund failures going forward. reports, The junk bond market has been bleeding for more than a year, with prices falling and yields rising. And while the carnage started in the energy sector, it has gradually spread throughout the high-risk bond and leveraged-credit markets.

Now, the troubles have claimed a major mutual fund victim — the Third Avenue Focused Credit Fund (TFCIX). The fund was chock full of junk bonds, stocks, warrants, loans and preferred shares, and those securities have been plunging in value.

Events like this are what market crashes are made of.  When you couple extreme selling pressure with a man-made lack of liquidity in the bond market, the results could tip the United States into the next recession.  The Dodd-Frank financial regulatory regime is onerous and has forced many large banks out of the bond business altogether.  Trading staffs have been slashed.  The upshot to this is there is just not much liquidity in the market.  This causes marked volatility when an investor has to sell to meet margin calls or just to protect his principal.

The recent fund failures could be the canary in the coal mine for the United States economy.  The Fed has waited so long to raise rate that their credibility is gone.  The Fed is now political, trying to keep the federal government from having to deal with its overwhelming sovereign debt.  Now the chickens are coming home to roost.

L. Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience.  He is also an author of historical fiction thriller novels.  His first of several books, Currency, deals with the consequences of overwhelming sovereign debt.  He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV.