Junk Bonds: No Free Lunch!

By | December 14, 2015

Summary: At two of the Wall Street firms I traded at there actually were free lunches! But at some point in time when the markets turned the free lunches would always come to an end! This concept of no free lunches holds true whether one is investing in real estate, junk bonds, stocks or commodities!

Flashback to December 3, 2015At levels not seen since the financial crisis, is the distressed debt ratio sending a clear signal about the health of the US economy? (Source)

Investing 101

What are some reasons investors buy junk bond funds instead of individual bonds?

  • Desire for more yield than what is available in less risky bond funds with portfolios comprised of higher-rated bonds.
  • Diversification and liquidity.
  • Investors limited capital that would preclude the ability to create a well diversified portfolio of individual bonds.
  • The fact that, unlike individual junk bonds where the small investors selling odd lots will likely be taken advantage of by traders, bond funds that are professionally managed allow for the quick sale of shares on any given day.
  • Finally, given the Fed’s 9-year 0% interest rate environment, investors who may not fit the risk profile for junk bond purchases have been forced out on the risk spectrum to try and get increased return on their investment dollars (see 1st bullet point).

Fast Forward to December 10, 2015Third Avenue Management said last week it was liquidating a $788 million credit mutual fund, fueling the biggest one-day selloff in the U.S. junk-bond markets since August 2011 on Friday. As the declines intensified and more investors demanded their money, hedge fund Stone Lion Capital Partners also suspended redemptions.

“We’re in one of those moments where all of a sudden there’s a complete liquidity gap,” said Geraud Charpin, a portfolio manager at BlueBay Asset Management in London, which manages more than $60 billion. “If everybody wants to rush for the door it’s not going to happen and more funds may have to temporarily gate. You want to appeal to calm.” (Source)

Painful Lesson For Some Investors And A Warning Sign For Others

The moral of the story and the lesson to be learned by both investors and government entities like the Federal Reserve, is that there are no free lunches and that when you increase risk the potential for bad things to happen increases right along with it!

Michael Haltman is President of Hallmark Abstract Service in New York. He can be reached at mhaltman@hallmarkabstractllc.com.

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