By Katy Burne
A shakeout in the junk-bond market is drawing only cautious
interest from bargain-hunters, underscoring investor fears that
many once-hot securities could prove hard to sell in an
increasingly difficult trading environment.
U.S. funds investing in debt rated below investment grade lost
an average 1.33% last month, according to a Barclays PLC index,
their second-worst monthly performance since November 2011. In June
2013, after the Federal Reserve began hinting that it would scale
back its monetary easing, they lost 2.62%.
The latest junk-bond decline intensified last week as investors
continued to make heavy withdrawals of money, in part because of
worry that a recharged U.S. economy could prompt the Fed to raise
interest rates sooner than expected, a move that would likely
pressure bond prices.
Reflecting the cautious mind set, some portfolio managers are
selling riskier bonds and replacing them with safer ones because of
concern about market liquidity, or the capacity to quickly buy or
sell securities at or near quoted prices. Many investors say
liquidity is drying up as the Fed pares its monthly stimulus and
large banks trim their bond inventories.
Investors pulled more than $5 billion in July from U.S.
junk-bond mutual and exchange-traded funds, according to Lipper, a
fund tracker, deepening the liquidity fears and adding to concern
that the recent selloff could intensify.
"Everyone is hoping to be first through the exit," said Matt
King, global head of credit strategy at Citigroup Inc. in London.
"By definition, that's not possible."
The downdraft in junk debt highlights concerns that purchasers
in the $1.6 trillion U.S. market, lured by higher income than on
government and highly rated corporate bonds, have paid too much for
the securities. Prices have rallied, sending yields to levels too
low to compensate buyers for the risk of the investments, many
investors say.
The tremors are being closely scrutinized across Wall Street.
Many investors this year have expressed concerns that a pullback in
junk-bond prices could signal that market participants are
rethinking their willingness to take risk, foreshadowing further
declines in stocks and other risky assets.
The conditions are heaping extra pressure on sellers at a time
when geopolitical unrest from Israel to Ukraine has caused a
pullback from stocks and all but the safest debt securities. The
Dow Jones Industrial Average has dropped seven of the past eight
trading days and is down 0.5% this year.
Jim Swanson, chief investment strategist at MFS Investment
Management, which oversees about $438 billion, said he has been
demanding extra yield on some bonds to reflect the risk that
selling could take longer, and avoiding some less-liquid bonds.
"There's a question of what happens when everyone tries to sell
[bonds] at once, and I want compensation for that," he said.
Brian Connolly, co-founder of hedge fund Millstreet Capital
Management in Boston, which oversees more than $200 million in
assets, said he recently tried to sell $3 million of energy company
bonds but couldn't find buyers for three days. Typically such a
sale takes a day at the most, he said.
"It has become increasingly harder to trade," he said.
Some investors have used the sales to bulk up on safer
securities such as higher-rated corporate bonds and U.S. Treasury
debt, fueling the latest rally in the ultrasafe bonds. The 10-year
Treasury note on Friday rose in price to yield 2.494%, down from
2.565% at the start of July.
Jeffrey Klingelhofer, a portfolio manager for the $1.2 billion
Thornburg Strategic Income Fund, said in June that his fund started
buying Treasurys for the first time in more than four years. The
fund has also built its cash position to 16% from 6% earlier this
year, and has reduced its allocation to junk bonds to half its
corporate-debt holdings from 60%, he said.
The problem also presents itself when traders need to buy bonds
in a hurry.
Ben Inker, co-head of the asset-allocation team at GMO LLC in
Boston, which manages $118 billion, said earlier this year he sold
some bonds short, betting their prices would decline. When it came
time to close out the trade, the firm "couldn't find any of the
bonds" to purchase and had to wait to complete the transaction, he
said.
Some investors blame lower inventories at banks that in the past
held a lot of bonds to fill client orders. Lately, they have been
shrinking those stockpiles to meet tougher capital requirements and
gird for an interest-rate increase.
Dealer inventories of high-yield corporate bonds fell to $4.8
billion in early July. That is the lowest level since April 2013,
when the Federal Reserve Bank of New York began publishing data for
separate types of debt, and down from $7.9 billion the previous
week.
Signs are rife that trading is thinner. Just 1.8% of outstanding
U.S. bonds changed hands on an average day in the first quarter,
down from 2.2% a year ago and a 2002-2008 average of 3%, according
to the Securities Industry and Financial Markets Association.
Some 73% of U.S. investment-grade corporate debt changed hands
in the 12 months ended in June, according to MarketAxess Holdings
Inc. That is the lowest turnover going back to 2004.
Tom O'Reilly, portfolio manager at Neuberger Berman, said he
believes the swoon in junk bonds will be temporary. Even so, he is
keeping cash levels higher than normal and reducing his holdings of
riskier debt, including triple-C-rated bonds.
When investors start worrying about risks, it "tends to lean on
high-yield prices," said Mr. O'Reilly, who oversees $40 billion in
high-yield bonds and loans. But "we think you will see money come
back into the market."
Corrections & Amplifications
July's average 1.33% decline in U.S. funds investing in debt
rated below investment grade was their second-worst monthly
performance since November 2011, according to a Barclays PLC index.
In June 2013, they lost 2.62%. An earlier version of this article
said the July decline was the worst in three years.
Chris Dieterich, Tom Lauricella and Al Yoon contributed to this
article.
Write to Katy Burne at katy.burne@wsj.com