A tale of two meltdowns: Ahead of US Federal Reserve meeting on rates, junk bonds flash signs of danger

ET INTELLIGENCE GROUP: Ahead of the US Federal Reserve meeting on rates, credit markets are flashing signs of danger. Third Avenue and Stone Lion Capital, the US-based high yield bond funds, have frozen redemptions. The cost of protecting debt against a default, measured in terms of credit default swap spread for speculative-grade companies in the US, jumped to 514 basis points, the highest since December 2012 and the average yield on these bonds increased to 8.43 per cent from a record low of 5.64 per cent in June 2014.

This has prompted investors to trim exposure to the risky instruments. As a result, the MSCI Emerging market index has started heading towards its lowest since 2009. The CBOE VIX — a fear gauge indicator for investors — gained 26.1 per cent, the highest percentage gain since June.

The SPDR Barclays High Yield Bond ETF, a proxy for high yield debt market, reached its lowest since July 2009 and crude prices dropped to seven-year lows. The rise in the average yield for bond funds will aggravate the problem for developing countries as they will have to bear the twin blow of higher interest rates and more payout in local currency due to dollar appreciation. Developing nations face an unprecedented $262 billion in repayment on bonds in 2016.

Analysts believe 10-15 per cent of bond funds may face withdrawals as more investors worry about their money, adding to the growing sense of alarm. Highprofile investors such as Jeffrey Gundlach, Carl Icahn and Bill Gross have warned there could be worse to come for high-yield debt. According to some observers, the situation is reminiscent of the 2008 financial crisis since companies are defaulting on their debt as they have been hit hard by the declining energy and commodity prices.