There is a reason why the Focused Credit Fund, a mutual fund that specialized in junk bonds, imploded on December 11 – the first fund to do so since the Financial Crisis. It experienced a run by its beaten-up investors and had to dump assets to cover the redemptions. This “forced selling” drove down prices even further. Finally, the fund blocked withdrawals. Instead, it would liquidate its assets gradually and pay the remaining investors the leftover subway tokens at some later time.
It was a classic liquidity mismatch, where a mutual fund held “illiquid” junk bonds, while investors were entitled to daily redemptions. This was exacerbated by the “first-mover” advantage in these kinds of open-end funds: the first investors out the door where made whole; those left behind ended up holding the bag [read… It Starts: Junk-Bond Fund Implodes, Investors Stuck].
The culprit? “Liquidity,” or rather the lack thereof, in junk bonds. The only way to sell junk bonds if you have to sell them is at a much lower prices – at which there suddenly is liquidity. And why was there no liquidity at the higher prices? Because there was no “dumb bid.”
That’s the theory penned with impeccable timing ten days before this implosion by junk-bond guru Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors, in a commentary on S&P Capital IQ LCD, titled beautifully, “Can liquidity exist without a dumb bid?”
His answer is no. There are two divergent “camps” among junk-bond market observers, according to Fridson:
One group bemoans the loss of liquidity, which is causing bonds to fall more sharply on bad news than in the past. The other contends that little has been lost because the high-yield market actually never had genuine liquidity.
Liquidity in the junk bond market, now that selling pressures are rising, is in terrible shape. Actually, it has been in terrible shape since the Financial Crisis – only no one complained because low liquidity when buying pressures were strong caused bond prices to soar. The Fed, bond-fund managers, and investors loved that. Financial advisors loved it. Everyone loved it. But now the direction has changed, and suddenly they’re all scared.
A portfolio manager who turns negative on a name and decides to liquidate a large position must be resigned to disrupting the market more violently than would have been the case prior to the Global Financial Crisis. Commentators in the bemoaning-lost-liquidity camp attribute this change to reduced dealer inventories, in turn resulting from tightened banking regulations, imposition of the Volcker Rule, and the transparency created by the introduction of the TRACE system’s essentially real-time trade reporting.
Those who deny liquidity ever existed argue that dealers never really used their own capital to act as shock absorbers, even if they made more of a pretense than they now do of maintaining continuous…