Did a Frozen Fund Lead Last Week's Outflows in High Yield?Learn more about this firm
- The circumstances of two large leveraged debt funds do not mean that investors with exposure to traditional high-yield funds are subject to the same outcomes.
- While we believe risk premiums should be higher for illiquidity and other risks, any technically-driven sell-off due to large redemptions could present a buying opportunity.
- Last week’s events are further evidence that disciplined credit selection based on strong fundamental analysis will be a key driver of manager performance over the coming year.
Jennifer Ponce de Leon, Senior Portfolio Manager and Head of High Yield
U.S. high-yield mutual funds finished last week in significant outflows, with $3.5 billion in cash withdrawals from retail mutual funds (72%) and ETFs (18%), as reported by Lipper. This represents the largest one-week redemption in the last 70 weeks since the record $7.1 billion outflow in August of 2014. While it is difficult to know exactly what drove the large redemptions, media coverage about two large leveraged debt funds that have frozen redemptions fueled concerns in the marketplace about the increasing illiquidity of the high-yield asset class.
We are not trying to make the case that the high-yield marketplace, along with other fixed-income sectors, is not experiencing liquidity challenges. However, the headlines around these two fund liquidations and subsequent challenges should not be misconstrued to imply that investors with exposure to traditional high-yield funds are subject to the same outcomes.
One of these funds is a hedge fund (not an open-ended mutual fund) that participates in the distressed market which is deeply illiquid. The other is an open-ended mutual fund that implements a high-beta, illiquid strategy resulting in a portfolio of less liquid securities that may be locked up due to restructuring events. Neither looks anything like the average traditional high-yield fund. But the initial coverage fed right into the fears of junk bond fund liquidity. While hitting the high-yield market particularly hard, last week’s news should not be regarded as an indicator of what is to come for all open-end high-yield bond funds. It should be viewed as a wake-up call to anyone using these funds to reach for yield (both funds in question offered very high yields relative to the traditional high-yield universe), to make sure they understand where their yield is coming from and decide whether the related risks are appropriate.
We are somewhat concerned by the possibility that investors misconstrue this information on fund redemption freezes, which in turn could lead to widespread withdrawals. But let’s be clear. The events of last week should not be a concern to the traditional high-yield mutual fund investor, nor should the sector as a whole be painted with the same broad brush.
We did see meaningful pressure in high yield on Friday as well as the equity market, and we do believe that risk premiums should be higher for illiquidity and other risks. However, depending on where valuations go, any technically-driven sell-off due to large redemptions could present itself as a buying opportunity. Although spread widening in commodity-related sectors is within reason, any widening in the rest of the high-yield market excluding energy, metals and mining could provide an attractive entry point.
We believe the combination of technical outflows and concerns about a global slowdown could cause the market to price in additional risk. Sentiment can often prove to be more powerful than fundamentals in the short term. If this transpires, we believe spreads of 200 basis points (bps) wide to historical medians, or +700 bps (excluding energy, metals and mining) would be an attractive entry point. We think investors who want high-yield exposure should enter the asset class in multiple stages, i.e., invest a little at a time each time spreads reach an attractive level until they hit their target allocation.
According to LCD, Lipper also reported that the higher redemptions could be a result of large seasonal distributions with re-investments not yet recognized, and it is typical to see large redemptions during this week of the year followed by large inflows as reinvestments are realized.
Regardless of what transpires, we believe this is further evidence that disciplined credit selection based on strong fundamental analysis will continue to be a key driver of manager performance over the coming year.
We also believe that funds that can take advantage of improving credit situations, avoid credits with deteriorating fundamentals, and remain disciplined in getting paid for taking risk will be best positioned to generate solid risk-adjusted performance in the next twelve months. Identifying managers who have demonstrated strength in credit research combined with the discipline to identify and price risk appropriately will be critical to outperformance in the current market environment.