The Accidental Distressed Debt Fund

Is the Third Avenue Focused Credit Fund the canary in the credit coalmine or a special bird that made the mistake of wrapping a bunch of distressed assets in a liquid mutual fund wrapper? That is the question currently facing bond investors nervous that the recent sell-off in credit could spread to other funds that specialize in buying the high-yield or junk-rated bonds sold by companies with more fragile balance sheets.

Open-ended high-yield mutual funds generally avoid buying distressed debt, typically defined as bonds whose risk premiums—known as spreads—over benchmark are higher than 1,000 basis points. But it's getting far harder for them to do that thanks to weakness in the credit market that has seen spreads widen and pushed a greater portion of corporate debt into distressed territory. The number of distressed bonds in the TRACE repository of trade data, for instance, has risen to a level last seen in late 2009 (and first witnessed in mid-2008, at the start of the financial crisis). Meanwhile, the proportion of triple-C rated bonds in the BofAML High-Yield Index trading at distressed levels has reached 66 percent.