Regulatory changes impacting high-yield liquidity

High-yield fixed income, while stung by the decline in energy and mining holdings, also is being seen as the first asset class hurt by regulatory changes that have cut liquidity in the fixed-income marketplace.

“There’s a new normal in terms of liquidity with the new regulations,” said Gregory Moore, vice president, head of traditional investment managers, Segal Rogerscasey, Norwalk, Conn. “This high-yield decline will go down as an important example of the effects of regulations on liquidity for years to come.”

The culprit, sources said, is regulations like the Volcker rule.

The Volcker rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that went into effect July 21, bans proprietary trading by banks and also makes holding inventory more expensive. It, along with other regulations under Dodd-Frank and European banking rules under Basel III, led banks’ trading desks to reduce fixed-income inventory, a traditional source of liquidity in the market, because of the added capital costs required to hold debt — particularly in high yield.

That cutback has hit high-yield debt harder because it can be harder to find buyers for the securities in those portfolios, particularly in energy, said Jas Thandi, associate partner, global asset allocation, Aon Hewitt Investment Consulting Inc., Chicago. “It’s not so much that you can’t sell a bond. It’s just price discovery. It’s more difficult to sell because it’s tougher to find liquidity.”

“Certain regulatory issues have led to lower broker-dealer and bank participation in certain credit markets, including high yield,” said Scott Malpass, chief investment officer of the $10.5 billion University of Notre Dame endowment, South Bend, Ind. “This lack of liquidity under the new regulatory rules has not been tested yet.”

But some think history may regard as the first test the closings earlier this month of the $788.5 million Third Avenue Focused Credit Fund and the $400 million credit hedge fund managed by Stone Lion Capital Partners, respectively, along with the liquidation of Lucidus Capital Partners, a $900 million high-yield credit fund.

David Long, senior vice president and chief investment officer, asset-liability modeling and derivatives and fixed income, at the C$60.8 billion ($44.2 billion) Healthcare of Ontario Pension Plan, Toronto, agreed the shutdowns and liquidation could be seen as the first examples of what could happen when liquidity in the fixed-income market declines.

“There is less liquidity out there,” Mr. Long said. “Intermediaries don’t offer the same amount of high yield as in years past. Because of that, pricing will be exaggerated, with large blocks having a disproportionate impact on pricing. Liquidity is something you pay for. It’s now more expensive to transfer something to someone else. The collective risk appetite is down. Regulations are a part of that.”

While liquidity issues throughout fixed income affected the troubled funds, Segal Rogerscasey’s Mr. Moore also said Third Avenue was in “a much deeper value-oriented strategy than most high-yield managers use, going into distressed debt and even some private equity. The more mainstream high-yield managers are down 7% to 10% year-to-date (Dec. 15) vs. Third Avenue, which was down 30%. Most mainstream high-yield managers are maybe holding 10% to 15% CCCs (rated bonds), the rest is 50/50 between BB and B. Those aren’t as liquid as investment grade.”

Dan Lomelino, director and head of North American fixed-income manager research, Towers Watson & Co., Chicago, said the Third Avenue problem raised the probability that a Securities and Exchange Commission proposal to expand required liquidity for mutual funds will be approved in 2016. According to the SEC proposal, mutual funds will be required to determine a minimum percentage of its net assets that must be invested in cash and assets that are convertible to cash within three business days “at a price that does not materially affect the value of the assets immediately prior to sale.” The proposal is up for public comment.

Mr. Lomelino said the regulation, if approved, “will have a far-reaching impact on bond mutual funds, on what they can hold … Anyone arguing that added mutual fund liquidity wasn’t needed, this Third Avenue situation strengthens the case for regulators.”