Third Avenue Redemption Freeze Sends Chill Through Credit Market

How Will Markets React to the Third Avenue Freeze?
  • Freeze on withdrawals comes as junk bonds head for annual drop
  • Biggest outflows in a year are a `dark cloud' over the market

Investors who piled into the riskiest corners of the credit markets during seven years of rock-bottom interest rates are getting a reminder of how hard it can be to cash out.

With outflows from U.S. high-yield bond funds running at the fastest pace in more than a year, Martin Whitman’s Third Avenue Management took the rare step of freezing withdrawals from a $788 million credit mutual fund on Dec. 9. The firm’s assessment that meeting redemptions would be impossible without resorting to fire sales has put a spotlight on the dangers for junk-bond investors as the Federal Reserve prepares to lift interest rates as soon as next week.

"It’s definitely a dark cloud over the market," said Anthony Valeri, a strategist at LPL Financial, a Boston-based financial-advisory firm. Investor withdrawals "are driving the high yield market now more than anything. Institutions -- hedge funds and mutual funds -- are being forced to get out and unfortunately that’s pressuring the entire market."

The selloff in riskier debt, fueled by tepid global economic growth and a collapse in earnings at commodity companies, deepened on Thursday as news of Third Avenue’s decision rattled investors. Yields on U.S. high-yield securities climbed to the highest in almost four years, putting the market on pace for its first annual loss since 2008, according to a Bank of America Merrill Lynch index.

Growing tumult in credit markets comes eight years after BNP Paribas SA helped spark a global financial crisis by freezing withdrawals from three investment funds because it couldn’t “fairly” value their mortgage holdings. While Third Avenue said its positions have the potential to deliver returns over a longer investment horizon, Berwyn Income Fund’s George Cipolloni said the similarities between today’s markets and those before the crisis are getting too big to ignore.

“A lot of this looks like late 2007 or early 2008,” when the credit crunch began to take root, said Cipolloni, whose fund has outperformed 72 percent of peers tracked by Bloomberg over the past five years. “But instead of housing and mortgages, it’s energy and materials leading the decline.”

Third avenue declined to comment beyond what was in its statement, Daniel Gagnier, a spokesman, said Friday.

Debt-laden commodity producers have been some of the hardest hit parts of the junk-bond market this year as prices for everything from oil to steel tumbled on signs of oversupply and weak demand from China. The slump is burning investors who relied on lower-rated bonds to boost returns as the Fed kept its benchmark interest rate near zero since 2008.

Many funds have also taken on greater liquidity risk in their hunt for higher yields. The Third Avenue Focused Credit Fund in many instances had purchased 10 percent or more of smaller bond offerings. Such large positions in infrequently-traded debt can make it difficult to exit. That’s particularly been the case in recent months as the aversion to commodities-industry borrowers spread to almost any debt that smacked of risk.

At the end of July, it held about a third of distressed tween-jewelry retailer Claire’s Stores Inc. $320 million of 7.75 percent bonds. Those securities lost almost half of their market value after just two trades on Dec. 1.

Many of the fund’s positions are in the debt of bankrupt companies, where gains can take months, if not years, to be realized. Third Avenue was the biggest holder of one set of bonds issued by bankrupt power producer Energy Future Holdings Corp., according to data through July 31. The 11.25 percent securities, which traded for as high as 121 cents on the dollar, have since lost 11 percent of their market value, last trading at 107.5 cents on Wednesday.

The fund, which had $3.5 billion in assets as recently as July 2014, suffered almost $1 billion in redemptions this year through November. Instead of meeting future withdrawals requests with cash, Third Avenue will redeem the fund’s shares for interests in a trust that will hold the focused credit fund’s assets -- primarily high yield bonds and corporate bank loans -- and liquidate them over time.

“It is highly unusual to see a liquidation of a fund of this scale,” Jeff Tjornehoj, an analyst with Denver-based Lipper, a provider of mutual-fund analysis, said in a telephone interview. “Normally it happens to funds with $10 or $20 million.”

Halting withdrawals is rare for a mutual fund. The Investment Company Act of 1940 requires them to stand ready to redeem their shares at net asset value on a daily basis. Suspending such redemptions would typically require an explicit authorization from the U.S. Securities and Exchange Commission, though Third Avenue’s trust arrangement could eliminate the need to get an SEC order, according to Jay Baris, the chair of Morrison & Foerster’s investment management practice.

“We are in communication with representatives of the fund and are currently monitoring the situation,” an SEC spokeswoman said.

In September, the SEC proposed new rules that would require funds to maintain a minimum cushion of cash or cash-like investments that can be sold within three days. Another proposal would allow funds to offer less favorable share pricing to investors who pull their money during periods of elevated withdrawals. Investors withdrew $3.46 billion from U.S. high-yield funds in the past week, according to Lipper.

Aside from growing concerns over liquidity and credit risks, bond-fund managers are also grappling with the impact of higher interest rates. Futures trading suggests 76 percent odds that the Fed will lift borrowing costs at next week’s policy meeting.

It’s a headwind that’s likely to keep weighing on high-yield debt markets, according to Jeffrey Gundlach, the chief executive officer of Los Angeles-based DoubleLine Capital.

“We’re looking at some real carnage in the junk-bond market,” Gundlach, whose $51.3 billion DoubleLine Total Return Bond Fund has outperformed 99 percent of peers over the past five years, said during a webcast Tuesday. “This is a little bit disconcerting that we’re talking about raising interest rates with the credit markets in corporate credit absolutely tanking.”