This commentary originally appeared on Real Money Pro at 9:54 a.m. ET on Monday, Dec. 14. Click here to learn about this dynamic market information service for active traders.
"It is simple and self-evident (that) the high-yield bond market is just a keg of dynamite that will sooner or later blow up."
-- Carl Icahn, CNBC's Fast Money (Dec. 11, 2015)
Wrong, Carl! It's neither simple nor self-evident!
I believe Icahn is wrong and hyperbolic as a leading voice in warning that high-yield-bond exchange-traded funds represent a systemic risk to our financial system. (See his recent Danger Ahead video for Icahn's thesis.)
I think the mega-investor is materially overstating high-yield ETFs' influence on the market -- and that they don't represent a systemic threat. Consider:
The Market Is Small
High-yield ETFs represent a very small percentage of total assets under management for high-yield bonds. Icahn is crediting them with more influence than they really have.
Size Matters
The list of high-yield ETFs with assets over $2 billion is short. There are only four -- the $15.2 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG), $10.1 billion SPDR Barclays Capital High Yield Bond ETF (JNK), the $4.2 billion Senior Loan Portfolio (BKLN) and the $3 billion SPDR Barclays Capital Short Term High Yield Bond ETF (SJNK).
The Market Is Diversified
The largest high-yield-bond ETFs aren't leveraged, but are diversified -- and easily track the high-yield indices. This is in contrast to the troubled Third Avenue Focused Credit Fund, which has a concentrated portfolio of illiquid, "off-the-rack" positions that are virtually unsellable.
Arbs and Market Makers Should Return
Expect arbs and market makers to move in and capitalize on the sector's large net-asset-value discounts.
Until the last few weeks' panic, the volatility of high-yield funds' NAVs had been falling, while fund-flow volatility was rising. This implies a maturing market structure.
As such, there could be a resurfacing of arbitrage once the current panic subsides, reducing NAV discounts. This stabilizing impact of arbs and market makers could offset any fears of retail outflows intensifying and creating further price distortions.
High Volume, No Price Disruption on Friday
Goldman Sachs remarked late last week that the market was handling the record-high junk-bond-ETF volume well -- more evidence of a maturing market structure.
To Goldman, that's a signpost that ETFs' ability to track their underlying NAVs remains intact. As an example, HYG traded 54 million shares on Friday vs. only 7 million on an average day. Although the high-yield market got whacked and less-liquid individual junk bonds suffered, there was no disruption in ETF prices.
Expect Scant Refinancing in the Medium Term
Risks in both the high-yield and leveraged-finance markets appear manageable given companies' maturity profiles. Even CCC-rated issuers have little debt to refinance over the next three years.
Activist Targets?
Should NAV discounts continue to expand, it's conceivable that managers of some smaller junk-bond ETFs might let their portfolios run off and make distributions to shareholders. Alternatively, some funds could become targets of activist investors, who would want to open closed-end high-yield ETFs. (Are you listening, activist Carl Icahn?)
Just look at the $700 million Blackstone/GSO Strategic Credit closed-end fund (BGB). That's a smaller fund that might be an activist candidate considering its current 16% discount to NAV.
This Is High Yield's Worst Non-Recession Year
High-yield spreads have widened by nearly 100 basis points since October's end, with oil, telecom, metals and mining accounting for the lion's share.
However, the widening spreads could conceivably be peaking right now just as investor appetite for risk eases -- and just as Icahn is adding fuel to the junk-bond fire. Much will depend on the outlook for oil prices and global economic growth.
Where Carl is Right
"I believe the meltdown in high yield is just beginning."
-- Carl Icahn on Twitter (Dec. 11, 2015)
Notwithstanding the above, Icahn is probably right is his argument above -- that we're at the end of bubble-era financing.
And in all likelihood, widening investment-grade and high-yield bond spreads will take a toll on equities. Historically, they almost always have.
The consequences of widening spreads have been a continuous subject in my diary for the last year. In fact, they're one of the foundations of my negative market assessment.
Sharply widening spreads likely spell a marked reduction in share buybacks and M&A activity, which companies often finance with investment-grade and high-yield bonds. Hence my Peak Buybacks, Peak Activism and Peak M&A views. Check out my quotes in a Barron's piece (subscription required) that came out over the weekend.
But as for Carl Icahn's investments, his positions in Freeport McMoRan (FCX), Cheniere Energy (LNG) and Chesapeake Energy (CHK) seem terribly wrong-footed.
Last week in a response to a question from CNBC's Scott Wapner, Icahn defended the indefensible by calling those holdings "activist"-inspired -- implying that in some way, their deteriorating end markets were just a sideshow.
But with the benefit of hindsight, Icahn grossly underestimated the deflationary pressures facing commodities (especially energy). He's made large investments in companies that face real and likely sustained operating challenges that no degree of activism will likely remedy.
That's why I'm "Peak Icahn" these days as well. Click here to see the dismal two-year price chart of Icahn Enterprises (IEP), which serves as a holding company for many of Icahn's investments. (Icahn owns 88% of the stock.)
IEP peaked at $125 a share two years ago, but closed on Friday at $66.
The Bottom Line
In summary, Icahn appears wrong regarding the systemic risk associated with high yield ETFs, partly because the ETF universe simply doesn't represent much in the way of total assets. Still, he's probably is right about the "knock-on" impact that widening junk-bond spreads might have on the U.S. stock market.
I have nothing but the utmost respect for Carl Icahn. In fact, I believe he and Warren Buffett might be the modern era's two greatest investors. But that doesn't prevent me from criticizing the things that either say or the investments that they make when I disagree with them. (I've been openly critical of some of Buffett's moves since 2010).
As for Icahn, some of his largest investments say to me that he doesn't practice what he preaches, or else he never would have made them. He's also gotten the equity class of some of his targets wrong. For instance, Icahn would have ironically been better off buying debt instead of equity with energy/resource companies.
Or maybe Carl should become an activist in the very space that he's critical of: high-yield ETFs. He could probably make more money doing so in 2016!
