The massive offer sent ripples through the junk-debt market: Hedge fund H/2 Capital Partners was seeking to offload nearly $800 million of a J.C. Penney Co. loan.

Traders are marketing the debt in the low 80s, potentially a steep discount for the first-lien loan, which had been changing hands for around 89 cents on the dollar. Credit insurance costs temporarily spiked and prices of other J.C. Penney debt dropped as investors caught wind of the offer Thursday.

It was the latest example of a common occurrence this year in the market for junk-rated corporate debt. After years of gorging on loans and bonds of even the riskiest borrowers -- all in a pursuit of yield that became increasingly sparse -- buyers have been drawing a line and either bypassing or demanding deep discounts to lend to companies that may struggle in an economic downturn.

This new caution has created a dearth of willing buyers for the lowest-rated companies, intensifying the typical year-end crunch. Investors have yanked money from funds that buy up leveraged loans for 54 of the past 55 weeks, and natural buyers like collateralized loan obligations are constrained in how much deeply-speculative debt like J.C. Penney’s they can hold. To make matters worse, it’s December, a time when liquidity typically dries up as firms get ready to close their books for the year.

“Things feel really squishy and weak on the buying side,” said Jason Dillow, chief investment officer of hedge fund Bardin Hill. His firm manages $10 billion in assets.

Under Pressure

Dillow said firms that focus on stressed loans are under increased pressure to eke out or maintain positive returns for the year, making them likely to shy away from the types of distressed credits that could blow up.

The potential pool of investors wasn’t huge to begin with. Funds that bet on troubled companies were sitting on about $80 billion of cash in July, a small sum considering that almost 40% of issuers of leveraged loans and high-yield bonds are graded B3 or lower, according to Moody’s Investors Service. The credit grader considers B3 rated companies with negative outlooks to be at risk of future distress.

Meanwhile, investors have been eager to deploy cash in the higher-quality tiers of junk debt. Twitter Inc., with credit ratings in the top range of high yield, managed to borrow at one of the lowest rates ever in the junk-bond market last week. Double B rated speculative-grade notes have returned more than 14% this year through Friday, compared with 5.4% for CCC securities.

Trading hefty chunks of debt in the opaque loan market can be difficult even in the best of times. Like elsewhere in the credit markets, leveraged loans change hands via a network of bank dealers that work their connections to find willing buyers. Post-financial-crisis regulations have made it more onerous for banks to keep large swaths of risky debt on their books, meaning that in a liquidity crunch, traders often don’t have the option of holding onto debt in hopes of receiving a better price later.

J.C. Penney wouldn’t be the first retailer to see its debt suddenly drop. The year has been full of fast blowups and liquidity pressure in the leveraged loan market. Party City Holdco Inc.’s $721 million loan plunged to a record low after the retailer slashed its profit and sales outlook for the year in November, citing weak Halloween store performance and helium shortages. The debt fell from 99 cents on the dollar to the low 80s in less than a week, before recovering to around 90 cents.

Even companies outside of retail have struggled. Earlier this year, media company Deluxe Entertainment Services Group Inc. saw its first-lien loan drop as much as 77 cents in three months to 12.5 cents -- a loss of more than than $600 million. It ultimately filed for bankruptcy.

Liquidity Risk

For J.C. Penney, things had been looking up. It recently raised its earnings forecast for the year, and its debt rallied as the company signaled it was focused on managing its borrowings. An 89 cents on the dollar price on its term loan is a level that indicates some stress, but no imminent disaster.

In fact, there are some signs investors have been more willing to buy loans in recent months.

“We’re seeing data that reflects healthy liquidity and two-way flows in the secondary loan market, particularly on the par side which accounts for 95% of all trade activity,” Ted Basta, executive vice president for market analytics and investor strategy at the Loan Syndications and Trading Association, said in an email.

According to the LSTA, trading volumes in the debt spiked 19% to a six-month high of $64 billion in October. But buyers were harder to come by earlier this year. The August and September tally of $105 billion was the lowest two-month total since the fourth quarter of 2017, according to the LSTA.

“Liquidity is there until it’s not,” said Angelo Rufino, co-head of credit at Brookfield Asset Management. Unlike prior downturns in distressed debt where loans might have dropped a few points, there are fewer willing buyers out there now for truly troubled credits, he said.

“Once the problem emerges for companies with severe secular risks, there is no price at which you want to own that risk,” Rufino said.