The shutdown of the distressed debt fund known as Third Avenue Focused Credit (TAFC), announced on the management company’s website on Dec. 9, has understandably created anxiety among retail investors. Until now, they have assumed that they could always get their money out the day they decided to.
With no warning, Third Avenue locked investors into its fund for a period it said might be up to one year or more by putting its assets into a liquidating trust. The company did not even bother to seek Securities and Exchange Commission approval for its action.
There are valid concerns about high-yield market conditions, highlighted by poor secondary market liquidity and the fact that the low point in the default-rate cycle is behind us. It would be a mistake, however, for investors to conclude that open-end mutual funds holding conventional high-yield bond portfolios are all at risk of being unable to meet redemptions and therefore pose a danger of a TAFC-like liquidation. Investors must understand the difference between distressed debt and ordinary high-yield bonds.
Currently, the BofA Merrill Lynch US High Yield Distressed Index accounts for just 11.62% of the market value of the BofA Merrill Lynch US High Yield Index. It has an option-adjusted spread (OAS) of 22.41%, and investors should expect about 30% of its issues to default within the next 12 months. The 88.38% of the high-yield universe represented by the BofA Merrill Lynch US High Yield Non-Distressed Index has an OAS of 508 bps. Over the next 12 months, the default rate for bonds currently in this index should be close to zero, as it is rare for the market to fail to identify bonds at high risk of default at least one year in advance.
Ownership of distressed bonds (those quoted at option-adjusted spreads of 1,000 bps or more) by ordinary high-yield mutual funds is usually inadvertent. The funds sometimes buy seemingly healthy credits that unexpectedly go bad. Occasionally, they decide not to sell, thinking the troubled issuer will turn around, only to wind up holding a defaulted bond. They do not, as a rule, deliberately play in defaulted debt, as was Third Avenue Focused Credit’s practice, as that paper generally provides no current yield.
Neither do conventional high-yield funds concentrate their holdings to the extent that TAFC did, with 28.4% of its assets in its top 10 positions. As a result, mainstream high-yield funds do not put themselves in a position of being unable to satisfy redemptions when default rates inevitably reach the point in the cycle where they stop going down and start going up.
Notwithstanding the stark dissimilarities between TACF, a distressed fund offering daily liquidity, and conventional high-yield funds, the search for the next domino to fall began soon after TAFC’s shutdown. Over the weekend the Wall Street Journal published a table entitled, “Throwing Out the Junk”.
It presented the 10 funds classified as high-yield under SEC rules, including Third Avenue’s distressed debt fund, with the largest year-to-date net outflows, ranked by the percentage of assets that those outflows represented. TAFC topped the list at 41%. The next three funds had net outflows ranging from 39% to 29%.
The four funds shared one characteristic that could contribute to an inability to meet redemptions, namely, very large requests for redemption. TAFC, however, was an outlier in terms of another key characteristic—humongous exposure to the sort of paper that is hardest to sell in order to meet redemptions. Based on Bloomberg data, 75.60% of TAFC’s market value was represented by bonds rated CCC to D or non-rated. The comparable figures for the other three funds ranged from 14.67% to 25.67%.
High-yield mutual fund shareholders should certainly take a close look at this simple metric for their own funds. Given that 63% of CCC-C issues within the BofA Merrill Lynch US High Yield Index are currently quoted at distressed levels, a ratio approaching TAFC’s would be a strong indication that the fund is in reality a distressed debt player, regardless of how it is classified by SEC rules.
In the present environment, that sort of fund could well find itself unable to continue offering daily liquidity. Conventional high-yield funds should not find themselves in that position, even though they may take sizable hits when they sell bonds to raise cash for redemptions. – Martin Fridson