BlackRock Inc.’s policy wonks did a post-mortem on the meltdown of a credit fund at Third Avenue Management LLC last year.
In a report submitted to policymakers and posted online by the Securities and Exchange Commission, BlackRock said the episode held lessons for regulators.
The report can be found below and for a summary check out Sarah Krouse of WSJ (also H/T there)
BlackRock’s Guide To Avoiding Another Third Avenue
Memorandum
[drizzle]To: Liquidity Risk Management Programs Proposal File
From: Amanda Hollander Wagner
Senior Counsel, Division of Investment Management
Date: January 20, 2016
Re: Meeting with Representatives of BlackRock, Inc.
On January 14, 2016, Andrew J. Donohue (Chief of Staff, U.S. Securities and Exchange Commission (“SEC”)), Jennifer Porter (Counsel to SEC Chair Mary Jo White), David Grim (Director, Division of Investment Management (“IM”)), Jennifer McHugh (Senior Policy Advisor, IM), Diane Blizzard (Associate Director, IM), Sarah ten Siethoff (Assistant Director, IM), Sara Cortes (Senior Special Counsel, IM), Melissa Gainor (Senior Special Counsel, IM), Kathleen Joaquin (Senior Financial Analyst, IM), Thoreau Bartmann (Branch Chief, IM), Naseem Nixon (Senior Counsel, IM), and Amanda Wagner (Senior Counsel, IM) met with the following representatives of BlackRock, Inc.:
- Barbara Novick, Vice Chairman;
- Benjamin Archibald, Managing Director (via teleconference);
- Kathryn Fulton, Managing Director;
- Joanne Medero, Managing Director (via teleconference);
- Jasmin Sethi, Vice President; and
- Alexis Rosenblum, Director, Government Relations.
Among other things, the participants discussed the Commission’s proposal on liquidity risk management programs and swing pricing.
BlackRock – High Yield Case Study: Post Closing Of Third Avenue Focused Credit Fund
Summary
- Third Avenue Focused Credit Fund’s announcement that it would abruptly cease redemptions was a highly unusual occurrence for US open-end mutual funds.
- TFCIX’s inability to meet redemptions did not result in problems at other open-end mutual funds; meaning we did not observe the “contagion” that some had hypothesized would occur if a daily open-end mutual fund was unable to meet redemptions.
- TFCIX’s portfolio composition was different from other high yield bond mutual funds, including lower credit quality, higher coupons, and less liquid assets.
- This episode provides an opportunity to revisit existing regulation and best practices around managing daily open-end mutual funds to ensure adequate investor protection and prevent future issues of this nature.
- Bond ETFs played a helpful role during this period of market stress by introducing a secondary source of liquidity via exchanges.
- We recommend several policy measures that can be taken by regulators and industry to avoid this issue in the future including:
a.Re-consider guidelines around fund classification and naming conventions.
b.Data reporting to regulators regarding the relative liquidity of open-end mutual fund holdings;
c.Communication with regulators and fund boards regarding illiquid assets, and
d.Supervision of funds experiencing distress.
On Wednesday, December 9, 2015, Third Avenue Manage-mentCompany (Third Avenue) notified shareholders of its Focused Credit Fund (TFCIX) that it would be making a distribution on or about December 16, 2015 of cash assets to shareholders as of December 9, 2015, and placing the remaining assets into a liquidating trust. According to Third Avenue’s letter to shareholders, no further subscriptions or redemptions of fund shares would be permitted as of December 9, 2015, and liquidation of the assets in the liquidating trust would be expected to take up to a year or more. As a 1940 Investment Company Act (1940 Act) open-end mutual fund, this was a highly unusual announcement and the Securities and Exchange Commission (SEC) “expressed concerns during discussions with the Fund and the Adviser”.1The board decision to move assets to a liquidating trust was subsequently rescinded by Third Avenue and on December 16, 2015, Third Avenue submitted an application to the SEC to request an order to suspend the right of redemption with respect to shares of TFCIX for the protection of shareholders (the Redemption Suspension Request), to be retroactively effective on December 10, 2015. On that same day, the SEC granted the request, issuing a temporary order2(the SEC Order) with conditions including that the fund reduce its holdings to cash, post its net asset value (NAV) on its website, and otherwise act only to liquidate the fund. Notably, the Redemption Suspension Request cites a “significant level of redemption requests by [TFCIX’s] investors over the past six months” as a reason the fund felt it was in the best interest of shareholders to cease redemptions.
An analysis of the fund’s portfolio as shown in Exhibits 1 through 5 indicates that TFCIX was not a typical high yield open-end mutual fund. Rather, TFCIX was a concentrated distressed debt portfolio with significant investments in securities in default, pay-in-kind bonds, Lehman claims, Fannie and Freddie preferred stock, and securities that were otherwise restricted from trading. Starting in mid-2014 and accelerating during 2015, the fund experienced significant outflows. According to Third Avenue, amid redemption requests at the fund and reduced liquidity in some parts of the bond market, it was “impractical” for the fund to pay off redeeming investors without selling holdings at fire-sale prices that would unfairly disadvantage the remaining shareholders. This was despite the fact that TFCIX had raised its cash position to over $200 million by early December 2015.3This combination of factors led Third Avenue to close TFCIX in this atypical manner.
Given the current regulatory focus on holdings of less liquid or hard to sell securities in funds that provide daily redemptions, attention moved immediately to questions of potential “contagion” in other parts of the high yield market. Concerns were expressed about the state of the high yield bond market, high yield mutual funds, high yield exchange traded funds (ETFs), and credit hedge funds. These concerns did not come to fruition as no other open-end mutual funds appear to have experienced the issues that were experienced by TFCIX. While the reporting on Friday, December 11, 2015 discussed TFCIX as a high yield fund, by Saturday, the media had acknowledged that TFCIXholdings appeared closer to adistressed debt portfolio. Adding to the drama, on Friday, December 11, 2015, Stone Lion Capital Partners L.P., a hedge fund firm specializing in distressed debt, indicated that it had suspended redemptions (as authorized by its constituent documents) in the $400 million Stone Lion Portfolio L.P., one of its hedge funds, after many investors submitted redemption requests.4This paper examines investors’ reactions in high yield markets and related products to Third Avenue’s announcement, and draws some lessons from this experience.
Background on Third Avenue
The following excerpt from Third Avenue Management Company’s website explains the origins of the company.
Marty [Whitman] founded M.J. Whitman & Co. in 1974 and invested in the mortgage bonds of then-bankrupt Penn Central Railroad. The excess return on his investment earned him a following from prospective investors, creating the foundation of Third Avenue Management. A decade later, Marty led the takeover of a closed end mutual fund, which he converted into an open-end fund. He invested the assets of that fund in the secured debt of a bankrupt oil drilling services company that is now known as Nabors Industries. As Nabors emerged from bankruptcy, the return to investors in the fund, who had exchanged their fund shares for equity in Nabors, was quite significant. The returns caught the notice of Morningstar, which named Marty Mutual Fund Manager of the Year in 1990.
Over time, Third Avenue expanded its product line and its management team. According to news reports, in 2002, Third Avenue sold 60% of the company to Affiliated Managers Group.6Assets under management (AUM) grew to $26 billion in 2006 before falling by more than half during the 2008 financial crisis.7As of March 31, 2015, Third Avenue had just over $10 billion in AUM across a series of mutual funds and private funds. In 2009, Third Avenue launched TFCIX.8The fund grew steadily from launch to 2014, peaking at over $3.5 billion in July 2014.9As of the end of November 2015, TFCIX had net assets of $942 million10reflecting a combination of significant underperformance and investor withdrawals.
Although TFCIX was described as a “high yield fund” and was in this category for performance comparisons,11our analysis of TFCIX holdings and the description of the TFCIX’s investment strategy in fund documents (see sidebar) suggests that TFCIX would be more accurately described as a concentrated distressed debt fund. In other words, the fund took concentrated bets on securities that were in default, restricted from trading, or subject to other issues that distinguished the bonds from other high yield securities of companies that are experiencing financial and operational distress, default, or are under bankruptcy. Distressed securities often carry ratings of CCC or below and have yield-to-maturities in excess of 1,000 basis points over the risk-free rate of return.
Analysis of TFCIX Portfolio Composition
We examined the composition of TFCIX and compared it to other high yield mutual funds. For purposes of the analysis, we compared TFCIX holdings to the BlackRock High Yield Bond Fund (BHYIX) and the T. Rowe Price High Yield Fund (PRHYX). We selected the other two funds for illustrative purposes as representative of traditional high yield open-end mutual funds. BHYIX and PRHYX have $16.2 billion12and $8.6 billion13in AUM, respectively, as of December 31, 2015. A simple analysis of the TFCIX portfolio as of July 31, 201514highlights that this portfolio included a significant allocation to distressed debt with credit quality that skewed noticeably lower than the other two high yield funds.
As illustrated in Exhibit 1, TFCIX had nearly 90% invested in assets that were rated Below B or not rated (NR). This figure compares to the Barclays US High Yield 2% Issuer Capped Index (the Benchmark), which has approximately 14% in Below B assets. Furthermore, TFCIX held over 41% of the portfolio in not rated securities, compared to less than 5% for each of the other two funds. Assets that are “not rated” are often less liquid than rated securities.
In addition, the TFCIX portfolio was focused on assets with significantly higher coupons than other high yield funds, and these holdings were much higher than the securities represented in the Benchmark.15Exhibit 2 shows the TFCIX portfolio invested more than half of its assets in securities with coupons of 10% or higher. In comparison, the Morningstar High Yield category average has only 3% in such securities and the Benchmark has just over 4% in securities with coupons greater than 10%.
Another indicator that a portfolio may experience liquidity constraints is the degree of concentration of portfolio holdings. The TFCIX portfolio held significantly more concentrated positions than other high yield funds as evidenced by the top ten holdings of TFCIX versus the other two funds. Exhibit 3 shows the top 10 holdings of TFCIX, BHYIX, and PRHYX, along with the percentage each holding
contributed to the total portfolio. In aggregate, the top ten holdings of TFCIX comprised 28.4% of TFCIX’s total assets, compared to 9.7% and 6.8% for BHYIX and PRHYX, respectively. Further, as Exhibit 4 shows, TFCIX’s top ten holdings had very high yields and significantly discounted prices reflecting the relatively low quality of these assets.
Using several different measures, TFCIX held a significant percent of the portfolio in less liquid or hard to sell assets. Liquidity tieringis one means of classifying the liquidity of portfolio holdings that assigns a liquidity “tier” to each asset type that a fund can invest in based on a qualitative and general assessment of the relative liquidity of each asset type (e.g., investment grade bonds versus high yield bonds) in both normal and stressed markets. Holdings are classified based on which asset type they fall under and exceptions can be made where the specific attributes of a particular position differ materially from the nature of the asset type as a whole. Exhibit 5 provides a breakdown of the percentage of TFCIX, BHYIX, and PRHYX that would fall under each tier using this liquidity tiering methodology. Under this approach, TFCIX held nearly 25% of its portfolio in Tier 5 assets, as compared to less than 2% in Tier 5 assets for each of the other two funds. While no single indicator alone can dictate that a fund has a liquidity problem, the liquidity problem becomes clear when looking holistically at the TFCIX portfolio.
Another measure that can be used as a proxy to determine whether a security may be relatively illiquid, is whether the security is a “Level 3” asset. Level 3 is an accounting / valuation concept that denotes securities that cannot be valued based on observable prices. While this does not necessarily mean that all Level 3 assets are illiquid, a high percentage of Level 3 assets in a portfolio can be an indicator of liquidity constrained holdings. The differences in the percentage of Level 3 holdings of TFCIX versus the other two funds is quite stark. TFCIX held almost 20% in Level 3 assets, while BHYIX and PRHYX held 3.8%16and 0.02%17in Level 3 assets, respectively. Put simply, the analysis shows that the composition of TFCIX’s portfolio was quite different from that of other actively managed high yield open-end mutual funds.
Comparing the holdings, TFCIX held a higher percentage of assets that fit in one or more of these categories: (i) below B and not rated, (ii) yields over 10%, and (iii) designated Level 3. In addition, the TFCIX portfolio assets were highly concentrated. These portfolio characteristics combined with the daily liquidity of a 1940 Act Fund resulted in a fund portfolio with liquidity issues.
See full PDF below.
