Whew! An inflow into high yield bond funds

Reports say investors put US$0.68 billion into high yield bond funds in the week ending August 13. That's a welcome relief after the US$7.1 billion outflow of the prior week.

Meanwhile, though, other worrying trends in the financial markets have Fed officials and bankers on edge. Liquidity is not as abundant in the "repo" market as it was. "Repos" are repurchase agreements in which borrowers sell government bonds (principally) for cash to a third party at the same time they promise to repurchase the bonds at a slightly higher rate in the future.

That some banks are reported to be reducing their role as middlemen in the repo market is important because financial institutions like banks and hedge funds use repos for funding. Repo markets froze up in the 2008 crisis, threatening the international financial system.

No one is suggesting that repo markets are on the verge of a 2008-style seizure. However, two Fed regional presidents  expressed their concern about repo markets this week. 

Investors pulling out of junk bonds...

In the week ended August 6, investors yanked a record US$7.1 billion out of junk bond funds, the Wall Street Journal reports. The prior record of US$4.6 billion was set in June 2013. The week ending August 6 was the fourth straight week in which investors cut their holdings in junk bond funds and a marked contrast to steady inflows early in the second quarter.

At the same time, yields on US treasuries have been declining.

The funds flows out of junk bonds are another reason to believe that portfolio investment flows are behind the recent depreciation of the peso.

Why has the peso jumped? There's Argentina...

On August 1, the International Swaps and Derivative Association (ISDA) “resolved that a failure to pay credit event occurred in respect of the Argentine Republic”. What does that mean? It means that any institution holding a credit default swap (CDS) insuring against a default by Argentina can collect. 

CDS are written by private parties. Banks and insurance companies (remember AIG?) developed a lucrative fee-generating business line by writing CDS. The notional value of the CDS written can -- and often does -- far exceed the nominal value of the debt being covered by the CDS. Estimates of the value of the CDS written on the defaulted bond issue are not widely known, if they are known with any exactitude.

By triggering the right to collect, the ISDA resolution opens up a can of worms. Over the coming days, we'll see how much exposure to the Argentine default there really is in the international financial system and which financial institutions are most heavily exposed. The issue isn't really who holds the actual bonds. It's which institutions bet that Argentina wouldn't default and they value of the CDS they wrote  based on that belief. 

The background:

Argentina entered into a technical default when it failed to make a debt payment to foreign creditors on June 30. The technical default became a real one a month later. It’s not that the country didn’t have the money to make the payment or even that it didn’t want to pay. The funds are sitting in a US bank awaiting transfer.

The situation is the consequence of a June 16 US Supreme Court’ decision that it would not accept an appeal of lower court rulings requiring Argentina to pay bondholders who refused to participate when the country restructured its debt earlier this decade as well as the holders of the restructured bonds. The US Supreme Court ruling also upholds lower court decisions that permit bondholders to issue subpoenas to banks to trace assets held abroad by Argentina.

The rulings are a major victory for those “vulture investors” who often bought the bonds at discounted rates in the secondary market and turned to the courts to enforce their right to payment in full. Be that as it may, the rulings will greatly complicate any future debt restructurings since the rewards for holding out have just soared.