Market Thought... Market Mechanics or Systemic Risk

The "junk bond threat" has been getting louder and louder. Although it was thruster forward with Mr Icahn pretty loudly a few months back. But recent Bloomberg chatter is that of pushing for a delay in rate hikes because of this threat. Miraculously enough, some very smart people are considering a .25 point rate hike a potential catastrophe to the likes of 2007. The severity-pedestal the junk market is given is a head scratcher. 

How will an issue with one isolated market, about $1-2trillion in size, cause such devastation?

In 2007, the subprime market was the starting domino that revealed gross inefficiencies with the regulations of the financial and insurance industries. Defaults revealed comical insurance on debt, that counter parties could not pay for, leading to horrific leverage, which revealed stupidly low bank capital reserves. The system was going through a domino effect, with no stop-gap built in. (Hence the Fed's QEs.)

This time around, money flowed to junk bonds. The market has been front loading the Fed hike for months but very smart people think the same domino effect will happen. Or they are sensationalizing the scenario for their positions. Does the risk truly exist?

Proprietary funds have been divested from banks. The banks have been going through consistent stress test since 2008. Their leverage is healthy. The capital reserves are arguably over flowing. Without the banks folding, there is no systemic financial risk. 

Worse case scenario is now off the table with a little common sense.

The junk bond market is ~$1-2T size market. Obviously it will cause hiccups. Every market is based on supply / demand. Quick selling in any market based security will cause a decline. If redemptions start coming in, as was evident Friday, assets get sold to meet these redemptions. Hence quick market declines. (Add some public knowledge of a known threat to spice up the day, and a market move gets exaggerated.)

Let's assume the junk bond market is $1.5T. Via a normal distribution curve, 20% of it is shit. (Shit meaning companies like Valent Pharma that will not be able to refinance their debt or get new debt, and will have to survive on cash-flow.) Most obligations will get paid but some will probably not. The credit markets maybe looking at $300B in default risk. (This maybe realistic given the energy related names that borrowed heavily with assumptions of higher oil prices. They have yet to see defaults but prob will if the market is shut out to them.)

Two funds made headlines blocking redemptions: Third Avenue and Stone Lion Capital. Understandable given the sizable declines in Junk bonds. 

The Junk bond ETF was handily beating the SP500 since the 2009 low, until the begining of 2015.

At the beginning of 2015 jnk was stalling, and by June, the selling into Fed tone-change was obvious. Smart money was leaving. Now its the naked players with the big boy induced exaggerated moves, praying off of fear.

Also evident, are the corresponding moves from one market to the other. But there is no correlation.

I'm not a bond guy, nor connected to high-yield offerings, but from the outside looking in, seems like the unprepared players will get hit while the prepared will take advantage of a crunch. Basically how markets are suppose to work.