Junk Bond Fund Junk
[Reprinted from the December 2015 issue of the LMR.]
As a CNN article explains:
“Third Avenue Management told investors on [Dec. 9] it is liquidating and blocking further redemptions after months of heavy losses and elevated requests from investors for their money back. The fund shrank from $2.1 billion in July to just $788 million on [Dec. 10]…Third Avenue said it will return a small portion of its assets to investors next week and then will focus on unwinding its investments. The fund anticipates it will take a year or more to fully liquidate. The mutual fund says it doesn’t want to resort to firesale prices just to meet redemptions. In fact, it blamed its troubles on the fast pace of redemptions combined with the lack of liquidity in the fixed-income markets.”
We will devote a full column to this topic in a future issue, but our quick take is that this event will prove to be far more significant than many currently realize. Institutional fund managers are now reevaluating their exposure to high yield (aka “junk”) bonds and in particular are realizing the market is not as liquid as previously thought. In our view, this is not simply a story about one particular fund taking too many risks when buying distressed debt.
It used to be the case that investment banks such as Goldman Sachs would provide the market with liquidity in this niche, in the form of “dealer inventory.” But after Dodd-Frank, bond dealers get penalized too heavily in their capital requirements when holding large amounts of high-yield bonds. Consequently mutual funds went around the new regulations by (among other avenues) seeking liquidity in high-yield bonds by turning to exchange-traded funds (ETFs) which were supposed to track their benchmark performance.
Thus the loss of dealer inventory and the miserable yields on Treasuries drove investors into riskier asset classes. But when investors who had previously parked their wealth in money market funds moved into the high-yield bond arena, they didn’t just sacrifice safety. They also gave up liquidity. These markets are simply not that deep, and so if something goes wrong—which it did—it can cause a wave of redemption requests and a self-fulfilling firesale prophecy. If and when the Fed continues to raise interest rates, we expect to see more of the financial sector’s vulnerabilities laid bare.