Falling Shelves

There have been many books piled on the Junk Bond shelf, and now they may be crashing. Corporate Debt outstanding has more than doubled since the financial crisis, while the balance sheet allocated to liquidity by the big banks has dropped more than 70%. Now that Third Avenue’s Credit Fund has suspended redemptions, the market is worried that finally we may be witnessing the liquidity collapse that everyone has been anticipating.

The difference this time is that the provision of leverage at the fund level is much less than was the case in 2008. Forced liquidations led to cascading failures as one investor after another met margin calls. Now, in theory, with so much less leverage provided by the street to hedge funds, they should be able to wait it out a bit more patiently. Redemptions are likely to occur as fund investors review their negative returns, but such a process can be managed in a more orderly manner over time. This is what Third Avenue has done.

Leverage at the corporate level is another concern. Debt/ebitda multiples have expanded dramatically in the last few years. Corporate issuers themselves, rather than funds, have been the recipients of extra liquidity. When that liquidity has been put to work in areas that are now over-invested, like Energy, asset returns go down and the debt becomes unsustainable. So this may be where the real danger plays out. Self-reinforcing deflation is the eventuality that policymakers around the world have been combatting with their multiple rounds of QE.

We’ve been in a world awash with liquidity and over-investment. If more sectors start to see deflationary price drops and lower revenues, bankruptcies are sure to follow. This will be a forced liquidation of another sort.