Third Avenue Smoke Doesn’t Mean High-Yield Fire by Ashish Shah and Gershon Distenfeld, AllianceBernstein

When a well-known mutual fund fails, investors get nervous. That’s understandable. But is the demise of Third Avenue Management’s Focused Credit Fund a canary in the coal mine for the high-yield market? We don’t think so.

It is, however, an important reminder of why it’s so critical to have a diversified high-yield strategy and to resist the temptation to reach for yield when the rewards don’t justify the risk—especially in today’s less liquid market.

High-yield investors often get into trouble when they reach too far for yield. For example, strategies that focus exclusively on distressed debt—a part of the market where you’re unlikely to get all your principal back all of the time—can start to come apart at the seams during market downturns.

So, too, can portfolios that are tilted heavily toward particular sectors. Many investors learned this the hard way when oil and gas prices plunged, causing energy company defaults to rise. Risky assets like these are relatively illiquid, and when they decline in value, they can be hard to sell quickly without taking a big loss.

This is why it’s so important that investors understand liquidity risk and have an investment process that can effectively manage it. That means taking a dynamic, multi-sector approach that allows investors to tap into a broad array of assets, offering better protection should liquidity in a specific sector dry up. It also means keeping enough cash on hand to meet redemptions and seize opportunities when they arise.

The gradual liquidation of mutual funds that fail will probably create some of those opportunities. And asset managers that have proactively managed liquidity risk and built liquidity buffers into their portfolios will be in the best position to take advantage of them.

The good news is that most high-yield managers have embraced diversified strategies that focus on a wide array of higher-quality assets. This is why we don’t expect to see a broad high-yield crisis.

Even so, here are a few things we think it’s important to remember:

1) Don’t reach too far for yield. Sure, it’s tempting with interest rates as low as they are. But remember, there are a lot of investors out there who are looking for ways to boost their portfolio income. All that demand has made it easy for companies to borrow, even those with fragile balance sheets and weak business profiles. Yields on many CCC-rated corporate bonds, for example, look enticing. But most aren’t high enough to justify the risk of default.

2) Concentrated portfolios may work in equities. Fixed income’s a different story. That’s because when it comes to bonds, success is often measured by what an investor doesn’t buy. To put it another way, if equity investing is about picking winners, fixed income is often about avoiding the losers. The only way to do that is to conduct a careful credit analysis and diversify across issuers, sectors and regions. Too many investors have lost sight of that in recent years, and have piled into risky areas of the market without being properly diversified. That’s a dangerous game to play in today’s less liquid bond market.

3) Demand transparency from your asset manager. Investors should know how their money is being invested and understand the risks they’re taking in their portfolios. Too often, they don’t. It’s likely that many of the shareholders in the Focused Credit Fund didn’t understand the kind of risk they were exposed to. This should be a wake-up call for mutual fund investors to demand more transparency from their asset managers. We think a Securities and Exchange Commission plan that would require funds to disclose more information about liquidity risk is a step in the right direction.

We expect high yield to remain volatile as the credit cycle enters its final stages and liquidity remains strained. That’s why it’s more important than ever to avoid the pitfalls of a concentrated, high-risk strategy.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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