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Third down

14 December 2015 By Neil Unmack

News of an investment firm blocking redemptions is a throwback to 2008. That’s one reason Third Avenue Management’s closure of a $789 million high-yield bond fund, preventing withdrawals, has rattled markets. The abrupt departure on Monday of David Barse, the New York fund firm’s chief executive, suggests flawed oversight, too. But contagion remains a risk.

The collapse of the Focused Credit Fund looks a bit like crisis early warnings, such as the conflagration of two Bear Stearns hedge funds and trouble at BNP Paribas’ money-market funds in 2007. It can, however, also be explained as an outlier.

Third Avenue’s fund invested in the debt of companies in financial distress, a niche, high-risk market that has been hit hard by falling commodity prices. The fund took illiquid positions but offered investors the opportunity to buy or sell daily. It wasn’t alone in losing money on investments, but parceling up hard-to-trade assets in a mutual-fund format was especially dangerous. Losses triggered a cycle of redemptions and forced sales, sealing its fate.

Even so, the wider credit markets reacted badly. The Focused Credit Fund closure helped triggered a near 50 basis-point jump in the average risk premium on junk-rated debt on Dec. 11, according to Markit data.

A particular concern is that investors have piled into risky debt in search of yield. Mutual-fund holdings of high-yield bonds exceeded $300 billion at their peak in 2014, twice the level in 2007, according to Citigroup. More bonds have been sold, too, but mutual funds can suffer from rapid reversals of sentiment. Meanwhile, tighter regulation of banks has reduced their ability to warehouse and trade bonds. That makes it more likely that a spate of redemptions leads to sharply lower market prices, more withdrawals, and so on towards a bank-like run.

One clear message is that investors, managers and watchdogs should pay greater heed to mutual-fund liquidity risks. On another front, investment firms might consider peddling structures that are less prone to runs, like closed-ended funds. Third Avenue may ultimately prove more of a cautionary tale than a canary in the coalmine – as long as complacency doesn’t prevent the learning of some basic financial and management lessons.


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