Third Avenue's Junk Bond Fiasco Reveals Liquidity Risks
Obviously there isn’t a 2008 crisis coming anytime soon, but mutual fund investors received a rude shock following the biggest mutual fund failure since then. New York-based Third Avenue Management is blocking investors from redeeming money from the near $1 billion Third Avenue Focused Credit Fund (TFCVX). Recently, Third Avenue Management announced the departure of its chief executive David Barse.
The fund house is closing the high-yield bond mutual fund Focused Credit Fund (FCF), but its investors will not get their money for “up to a year or more.” Third Avenue Management is trying to liquidate the fund’s assets. This marks the biggest mutual fund failure since Primary Reserve Fund "broke the buck" back in 2008. Moreover, this comes at a time when the Federal Reserve is expected to hike rates for the first time in a decade. As an aftermath, U.S. junk bonds registered their biggest decline since 2011 last Friday.
The failure and the embargo on investors on withdrawals also highlight the concerns related to liquidity in corporate bond markets. It proves how dangerous it is to pile up risky assets that find no sellers even when times are favorable. A Reuters report shows that at least one-fifth of the fund included illiquid assets and their infrequent trade means that they have no market price.
The liquidation also raises doubts over how prepared fund managers are during large redemptions for funds that hold a large chunk of hard-to-sell assets. Remember, in September, a five-member Securities and Exchange Commission (“SEC”) had unanimously voted to recommend new rules to help the multitrillion asset-management industry with effective liquidity risk management. Now we realize how crucial the rules are.
Trouble for TFCVX
Year to date, TFCVX is down 27.1% and its 1-year loss is at 29.1%. TFCVX had suffered $20 million of losses on debt issued by firms from the chemical sector. It also lost $15.5 million related to the food and beverage industry. According to Lipper, the average loss in the junk bond sector is 3%, which further magnifies TFCVX’s year-to-date loss slump. Amid such high redemptions and losses, the fund probably had no way out than to bar withdrawals. The fund failed to continue without selling assets at heavy discounts, paying the price for reduction of liquidity in the bond market and huge withdrawal demands.
Third Avenue Focused Credit Fund has lost more than half of its assets in just about four months. Since the end of July, the fund’s size was cut from $2.1 billion to $1 billion. Last week, assets totaled just $789 million. In November, net investor redemptions were $319 million. A year back, Third Avenue Focused Credit Fund held $2.75 billion in assets. Of these, 18% was exposed to securities considered illiquid. These illiquid assets included common stocks and warrants belonging to the energy sector, convertible preferred stocks and corporate term loans.
In a letter dated Dec 9, Third Avenue Management stated: “Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”
Third Avenue also informed that it has adopted a Plan of Liquidation. The letter mentions: “Pursuant to this Plan, on or about December 16, 2015, there will be a distribution to all FCF shareholders of the Fund’s cash assets not required for the expenses of the Fund and its liquidation. The remaining assets have been placed into a liquidating trust (the “Liquidating Trust”) and interests in that trust that identifies the Floating will also be distributed to FCF shareholders on or about December 16, 2015. These two distributions will constitute the full redemption for all shares of FCF and existing FCF shareholders will all become beneficiaries of the Liquidating Trust, which will make periodic distributions as cash is received for the remaining investments. The record date for these distributions is December 9, 2015, so no further subscriptions or redemptions will be accepted.”
SEC Knew it was Coming? Proposals to Lower Liquidity Risk
In September, SEC proposed additional safety measures that will require mutual funds and ETFs to implement new plans to manage liquidity risks. The proposal calls for funds to keep a minimum amount of cash or cash equivalents that can be easily sold within three days (down from seven days currently required for mutual funds). Moreover, fund families may charge investors who redeem their holdings on days of increased withdrawals.
Under the proposal, mutual funds and ETFs must implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. These would lead to the timely redemption of shares and collection of assets by investors without hampering the day-to-day running of the funds.
Further, the open-end funds will have to allow the use of “swing pricing” in certain cases. Swing pricing is a liquidity management tool designed to reduce the dilution impact of subscriptions and redemptions on non-trading fund investors. This step would enable mutual funds to reveal the fund’s net asset value (NAV) costs related to shareholders’ trading activity.
In addition, the proposed reforms would put a 15% cap on investments that can be made in hard-to-trade assets. As reported by The Wall Street Journal, some of the largest U.S. bond mutual funds have 15% or more of their money invested in such illiquid securities.
Torrid Times for Junk Bond Funds
Junk bond fund managers are in rough waters, which worsened by the rout in energy sector. Some managers are of the view that the junk-bond pricing volatility reflects the 2008 financial crisis.
These mutual funds will suffer more now after the Fed hiked the key interest rates. A rise in rates will lead to bond exodus; when lack of liquidity may compel investors to sell the asset class at significant discount.
Redemption of bonds would increase the selloff and then fund managers will have to sell the less liquid assets to match investors’ cash demands. However, if a mutual fund or an ETF holds illiquid bonds, the price swings will be rapid and would create a vicious cycle as price drops will again intensify selling pressure.
Carl Icahn tweeted: “Unfortunately I believe the meltdown in High Yield is just beginning.” Under such circumstances, investors may choose to stay away from the high-yield mutual funds.
Below we highlight 3 mutual funds, apart from TFCVX, that carry either a Zacks Mutual Fund Rank #4 (Sell) or Zacks Mutual Fund Rank #5 (Strong Sell). Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but also on its likely future success.
These funds have nosedived this year and also over the last one-year period. Also, they hold less than 5% cash and less than 5% stocks; thus running down the option of holding highly liquid assets.
JHancock Core High Yield A (JYIAX) invests the bulk of its assets in corporate debt securities. These securities are rated below investment-grade and are considered high-yield and junk bonds.
JHancock Core High Yield A currently carries a Zacks Mutual Fund Rank #5. It has lost 7.7% year to date and slumped 5.3% over the last one-year period. Annual expense ratio of 1.07% is higher than the category average of 1.05%. Looking at asset allocation, just 3.89% and 0.17% are allocated to cash and stocks, respectively, while 92.19% is allocated to bonds.
Franklin High Income C (FCHIX) invests mostly in high yield, lower-rated debt securities, or junk bonds. These securities comprise bonds, notes, debentures, convertible securities and senior and subordinated debt securities.
Franklin High Income C currently carries a Zacks Mutual Fund Rank #5. It has lost 11.1% year to date and slumped 7.9% over the last one-year period. Annual expense ratio of 1.26% is higher than the category average of 1.05%. Looking at asset allocation, just 4.74% and 0.17% are allocated to cash and stocks, respectively, while 94.12% is allocated to bonds.
Delaware High-Yield Opportunities A (DHOAX) invests a large portion of its assets in fixed income securities. These securities at the time of purchase are rated below investment-grade. DHOAX also invests in corporate bonds of foreign issuers.
Delaware High-Yield Opportunities A currently carries a Zacks Mutual Fund Rank #5. It has lost 7.3% year to date and slumped 4.2% over the last one-year period. Annual expense ratio of 1.07% is higher than the category average of 1.05%. Looking at asset allocation, just 3.19% and 0% are allocated to cash and stocks, respectively, while 93.31% is allocated to bonds.
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