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As Wall Street Vultures Circle The Next Junk Bond Fund Casualty, A Familiar Name Emerges
Now that all the suspense surrounding the Fed’s rate hike is gone, and only questions about the future of risk assets and deflation remain in a “Policy Mistake” world, the market’s attention is turning back to the disturbing topic which spread like wildfire two weeks ago when first Third Avenue, and then several more mutual and hedge funds announced they would liquidate while imposing redemption “gates.”
To be sure, the spin doctors scrambled to make the Third Avenue junk bond fund collapse a unique, one-off situation, however subsequent fund flow data released late last week suggested that the pain for debt (and especially high yield) funds is only beginning. As we wrote on Thursday night, in a development that is certain to further exacerbate the (in)stability of the bond market, Bank of America wrote that there was “Carnage in Fixed Income” as a result of the largest outflow from junk bond funds in at least a year.
It wasn’t just junk: as the FT chimed in, investment grade – that all important category for funding stock buybacks – was also slammed as “investment grade bond funds in the US have been hit with a record wave of redemptions, a week after two high-yield funds announced they would shutter and another barred withdrawals as the credit market showed further cracks.” This was the largest outflows since Lipper began tracking flows in 1992.
And despite rising briefly, bond prices resumed their fall over the past week following the fading euphoria from Yellen’s rate hike decision (which is very adverse for all fixed income products) the combination of redemptions and further price declines will quickly turn quite deadly for many funds who have been scrambling to juggle both sliding AUMs and droppinh prices, and are hanging on by a thread.
So in what may be an attempt to create some more volatility (after all a flatter yield curve means that only a surge in volatility can help bank profits) Citi’s William Katz writes that he “spent the last few days combing AUM releases, prospectuses, Morningstar, Simfund, and Statements of Additional Information in an effort to gauge High Yield dynamics across our Coverage universe” and specifically to determine which mutual fund(s) will follow Third Avenue next into the twilight zone.
And so Wall Street has set its sights on the next junk bond fund casualty, a name which is well-known to most equity market participants: none other than Waddell and Reed (WDR), the fund which rose to infamy in the aftermath of the May 2010 Flash Crash, after it was initially blamed by the SEC as the culprit behind the Dow’s 1000 point crash, at least until the entire fiasco was re-blamed this past April on an Indian spoofer out of London, Nav Sarao who now faces life in prison just so the regulators can keep attention away the real market destabilizing, high frequency trading culprits.
According to Citi, while the sector faces varying risks within the category that are likely to amplify attrition in the near term, Waddell seems most vulnerable for four key reasons:
- large percentage of U.S. Retail AUM;
- greatest percentage of LT AUM;
- among worst in class performance metrics; and,
- perhaps most worrisome, the highest allocations to CCC+ or lower rated investments within the largest Retail HY funds at the firm level – the latter potentially problematic should liquidity remain scant and/or credit take a further turn for the worse.
To be sure, Citi does not want to be blamed for inspiring a bond fund panic, and caveats its forecast by saying that “the whole sector is overweight risk as all the players are overweight CCC+ or lower rated securities versus HYG (BLK’s HY ETF). While WDR is most at risk to elevated attrition, in our view, the Group at large could face a pick-up in redemptions, particularly given: 1) move by the Fed to raise interest rates; 2) aging economic cycle; and, 3) adverse seasonality before considering longer term ramifications associated with the pending DoL Fiduciary Reform proposal. That said, C’s strategists see some improvement in HY returns into ’16, suggesting attrition pressure could alleviate into the new year; though we see APAM, FII and TROW as the largest incremental beneficiaries.“
Disclaimer in place, the writing of Waddell’s epitaph resumes: “Why is WDR in the worst shape? Four reasons: 1) HY is among highest percentage of U.S. Retail; 2) the category also amounts for among the highest percentage of LT AUM; 3) performance is among worst in class; and, 4) WDR is in the top three most levered to the highest risk investments in HY, with 46% of the portfolio rated CCC+ and below vs. a median of 22% for peers.”
In its evaluation of Waddell’s risk, Citi first gauges its exposure:
In Figure 1, we show Active Retail High Yield AUM relative to Total Retail LT AUM. Here AB (11%) and WDR (10%) have the highest level of Retail HY exposure, while IVZ (1%), AMG (1%), and BEN (1%) are seemingly least impacted.
Next, Citi highlights Active Retail High Yield AUM relative to Total LT AUM (Retail + Institutional). Here WDR has the highest level of total exposure to HY followed by FII with 8% and 6%, respectively. Citi does however note that AB becomes less at risk when looking at its HY exposure against total assets.
Another problem emerges when looking at flagship HY funds at each company relative to Total LT retail AUM. WDR has the highest leverage to one fund (High Income at 10%) followed by AB (High Income at 9%).
Next, Citi looks at flow dynamics, and shows AUM and flows for each of the funds. It notes three key observations: 1) majority of YTD Fund flows have been negative with a few exceptions; 2) BlackRock High Yield Bond Fund has been the biggest gatherer of net flows with $3.2B of inflow YTD (as of 11/30); while, 3) Waddell’s High Income Fund has seen the highest level redemptions with $1.9B of outflow (as of 11/30).
Finally, Citi breaks down the credit quality of each fund based on percentage of the portfolio with a credit rating of CCC+ or lower. All respective fund portfolios have a higher percentage of CCC+, or lower rated, products compared to HYG. HYG is used as the proxy for the HY index, as investors use the ETF as a proxy for overall High Yield performance and sector/credit rating exposure.
Citi finds that AMG’s Third Avenue Focused Credit had the highest percentage of its portfolio levered to CCC+ or lower at 76% followed by Artisan’s High Income (55%) and WDR High Income (46%). On a comparable basis, HYG has a ~9% allocation to CCC+ or lower.
Here is how Waddell stacks up by industry and credit quality relative to the HYG benchmark.
In short, for Waddell And Reed the shorting sharks are circling, desperate for the drop of blood that will set them over the edge, even as the Wall Street vultures are once again circling above, sensing that the next risk-flaring catalyst is about to keel over and die.
How to profit from this imminent death, in true Wall Street fashion? For all those who would like to repeat the Third Avenue paradigm and short the bonds most widely held by Waddell, in the process accelerating the fund’s demise and unleashing a liquidation scramble which would send the bond prices even lower, here is the list of top bonds held by WHIAX.
Finally, here is Citi explaining why the demise of Third Avenue is just the beginning of an avalanche that will have dramatic consequences for the entire junk bond space: “The mismatch between FI and dealer inventory leaves very little room for error, particularly should either credit further deteriorate and/or liquidity further dry up, the latter certainty not aided by the Fed raising ST rates.“
Source: http://silveristhenew.com/2015/12/19/as-wall-street-vultures-circle-the-next-junk-bond-fund-casualty-a-familiar-name-emerges/
