Third Avenue Management said this week that it’s liquidating its Third Avenue Focused Credit Fund – a move that signals not only problems for the firm itself but also concerns for the corporate junk bond market as a whole. Indeed, Third Avenue isn’t the only corporate bond fund that’s liquidated this year, and such a high-profile (albeit small) fund joining the outflow is indeed indicative of broader problems.
Also activist investor Carl Icahn warned today that he thinks the high yield meltdown “is just beginning.”
Wall Street plagued by tumbling junk bonds
The high-yield bond fund has about $790 million in assets under management, and management decided to liquidate it because investor redemptions have been outpacing their efforts to liquidate without just running a fire sale. Third Avenue chalked up the problems to the poor bond market, which management said made them unable to raise enough cash to meet the pileup of redemption demands from investors, The Wall Street Journal reported on Thursday.
The problem is that “corporate bond holdings have stagnated as corporate bond issuance has moved to record levels,” said Evercore ISI analysts Dennis DeBusschere, Brian Herlihy and Max Trunz in a report dated Dec. 11. The liquidity problems are arising because of this sudden stagnation, which has caused investors to start pulling their cash all at the same time.
Third Avenue halts redemptions
In what is a rare move for mutual funds, Third Avenue is no longer accepting any more withdrawals for the time being. This means that investors who still have money in Third Avenue’s Focused Credit Fund won’t see all of their money for months or possible even longer. It also means that management is attempting to liquidate the fund in an orderly manner without a fire sale.
Investors whose money is stuck in the fund right now will earn interest in the liquidating trust without management fees. They will receive cash distributions gradually, possibly lasting throughout next year and maybe even longer.
Third Avenue’s FCF down 22%
Goldman Sachs analyst Alexander Blostein and his team noted in a report dated Dec. 11 that so far year to date, the Third Avenue Focused Credit Fund has declined 22% or about 890 basis points in excess performance. That ranks the fund in the 99th percentile compared to its peers, according to Morningstar. Data from eVestment indicates that the fund holds Caesars in addition to some other leveraged buyouts backed by sponsors.
Also commentary from the fund’s management indicate that some of its investments have been restructured lately. Because of the slide in performance, the fund has seen about $680 million in outflow so far this year, compared to a total of $630 million in all of last year.
Liquidity issues in the high yield income market
The Goldman Sachs team said Third Avenue’s liquidation of the fund demonstrates just how serious the liquidity problems are in some parts of the high fixed yield income market. These liquidity problems have crossed over into huge problems for money managers, particularly as the pace of redemptions has picked up. The Goldman team sees smaller managers (like Third Avenue) as being at greater risk than larger ones.
They noted also that they’ve seen redemptions from taxable bond funds pick up recently as well, as they hit about $65 billion during the second half of the year compared to the $51 billion in the first half. High yield fund outflows are driving this higher rate, and they expect redemptions for these funds to remain elevated as investors become risk averse and the ongoing liquidity problems exacerbate the price declines in the high yield market.
Illiquidity spreads
Deutsche Bank analyst Masao Muraki notes in a report dated Dec. 11 that most of the liquidated funds have been closed-end fund, while Third Avenue’s fund is an open-end fund. This indicates that the liquidity problems in the high yield bond market are moving into the next stage. The International Monetary Fund warned earlier this year that blocking redemptions as Third Avenue has done could cause an increase in requests to other similar funds. Muraki also noted that the last financial crisis began in August 2007 with mass quantities of redemption blocks by open-end mutual funds that had funds in securitized products (or so-called “Paribas Shock”).
However, he also adds that a single redemption block from one firm doesn’t necessarily mean that other funds will see the same thing. He points out that third Avenue’s FCF was investing in bonds with ratings as low as CCC. As a result, it is more exposed to the liquidity problems than the majority of high yield investment trusts, which typically focus more on BB or B ratings.
The Deutsche Bank analyst recommends that investors simply remain calm and monitor credit prices. The Financial Stability Board is calling for funds to run liquidity stress tests, and Muraki is focusing on corporate bond spreads with BB ratings and leveraged loan indexes.
High yield shifts to net outflows
In a report dated Dec. 10, Bank of America Merrill Lynch strategists Michael Contopoulos, Michael John and Neha Khoda said that this week high yield funds in the U.S. shifted to net outflows. They noted $3.4 billion in outflows or a decline of 1.6% and added that this is the biggest outflow in high yield funds since August 2014 when the market saw $6.75 billion in outflows following the downing of a Malaysian Airlines plane over Ukraine.
The BAML team chalks up this week’s outflow to the frustrations of retail investors, who have witnessed months of negative returns for high yield funds in the U.S. and also a -3.6% total return since the beginning of last month. Further, the end of the year is approaching, so they believe investors are unloading assets that have posted negative returns this year, which enables them to write off those losses against the better performances of other assets.
Open-end funds dominate high yield outflows
They noted that most of the outflows so far have come from open-end funds, which racked up $2.64 billion in outflows or a decline of 1.5%. However, they also said high yield exchange-traded funds have lost more on a percentage of NAV basis at $759 million or a 2% decline.
Thus far year to date, the U.S. high yield market has racked up net outflows of $806 million or a decline of 0.3%. This brought them into the negative after spending part of last month on the positive side. High yield funds from outside the U.S. have performed slightly better with $412 million in outflows or a decline of 0.2%. However, this was still their first time in the red in nine weeks, the BAML team said.
