News headline story
By Christopher Whittall
U.S. corporate bond funds are sending out a distress signal in global markets, according to Sean Shepley, a managing director at Credit Suisse Group AG.
Specifically, U.S. closed-end credit funds are exhibiting levels of stress not seen since the 2007 to 2008 financial crisis, Mr. Shepley said.
Here is a quick run-through of the potential problem:
First, what’s a closed-end bond fund?
Closed-end funds issue a fixed number of shares that then can be bought and sold by investors. This contrasts with open-ended funds, where new shares can be created to meet investor demand. Closed-end credit funds pay out dividends to shareholders financed by returns they make on investments in U.S. corporate bond markets.
What is the problem?
These funds are trading at an abnormally large discount compared to the value of the assets they hold. That discount level has only been higher back around the financial crisis of 2007 and 2008. It’s currently between 10% and 15% depending on the fund, according to Mr. Shepley. It’s usually closer to 5%.
Why the discount?
Funds will often trade at a discount if investors think their dividends are set to fall. This can be because investors expect an increase in credit risk (rising corporate defaults) or liquidity risk (meaning it is harder to buy or sell large amounts of bonds without paying a hefty price to do so). And it is worth bearing in mind that many of the corporate bonds these funds invest in are not the most liquid investments to start with.
When investors are concerned about the prospects of the wider economy, and therefore how corporate bonds will perform in the future, the discount should rise. It should also increase if investors want to keep hold of more cash because they are worried financial markets could be in for a tough ride.
So why is this discount rising now?
Because parts of financial markets are having a torrid time of it lately. Commodity prices are falling, emerging markets are getting hammered, and the U.S. Federal Reserve hasn’t even raised interest rates yet. These moves have spooked investors.
Moreover, the Fed raising interest rates will increase the cost of borrowing money. This should reduce the return of strategies that borrow money to buy bonds, like closed-end funds.
Even so, fund discounts are “abnormally large compared with recent history”, said Mr. Shepley.
“Investor risk appetite has recently been undermined by a series of shocks to commodity prices and the value of emerging market assets and we think it likely that this has contributed to growing concern over credit assets in U.S. markets as well,” he said.
Should we be worried?
It’s certainly something to keep an eye on. If discounts were to increase further from current levels “it would probably signal a significant deterioration” in the outlook for global markets, said Mr. Shepley.
(END) Dow Jones Newswires
August 03, 2015 09:39 ET (13:39 GMT)
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