Franklin's Big Bond Bets Raise Liquidity Concern
Worrying about bond-market liquidity has gone out of vogue. But some real risks linger.
A good example can be found in Community Health System’s $14.5 billion of bonds, which are facing some serious challenges. The most obvious one is that the for-profit hospital operator has some fundamental credit-related problems, which the price of its bonds isn't reflecting yet. Gadfly outlined some of those issues last week.
But Community Health and its investors have another more technical issue to worry about. Franklin Income Fund owns more than $2 billion of Community Health’s bonds, or more than 16 percent of the debt outstanding, according to data compiled by Bloomberg. This one fund owns more than $900 million of the hospital operator's bonds maturing in 2019, or about 47 percent of those outstanding.
This is unusual for a mutual fund, even one as big as Franklin. And it has garnered the attention of some credit traders, who see a potential problem -- or perhaps an opportunity. What happens if the Franklin fund decides it no longer likes Community Health’s bonds and tries to sell them? Or let’s say the fund receives redemption requests from investors and has to liquidate a good portion of its portfolio. What happens then?
In either case, it's easy to see how prices of Community Health bonds could plummet as Franklin sought to sell them. Even if the fund moved slowly, word gets around in the gossipy, all-too-human $1.3 trillion U.S. high-yield bond market. This is especially the case with less-traded securities that have some of the lowest credit grades, like Community Health's debt.
Just think about what happened with the Third Avenue Focused Credit mutual fund, which blew up in December 2015 as it struggled to meet withdrawal requests. That fund owned a lot of infrequently traded debt of highly leveraged companies, which it couldn’t sell easily without taking huge losses.
Franklin Resources and its funds have a history of making bold bond bets on places from Ukraine to Puerto Rico and in industries like beaten-up U.S. oil and gas drillers. Some of these wagers have worked out well; others less so. Either way, the firm doesn't shrink from its contrarian reputation and has experience navigating it.
The firm's Income Fund oversees more than $83 billion of assets and has been around since 1948. While it has a substantial position in Community Health, those bonds account for a little less than 3 percent of the fund's total assets.
That said, these big wagers present a challenge. Are other investors willing to buy these Community Health bonds knowing that Franklin could completely decimate their value if they change their view on the notes? Meanwhile, the Income Fund also has a significant stake in Tenet Healthcare's debt, which is in a similar situation to Community Health. If one of the hospital companies runs into trouble, there's a good chance the other will, too.
Franklin serves as a good example of the type of liquidity risks that remain in U.S. credit. Its Income Fund and any others like it most likely won't crater the broader market. But they present a serious threat for specific companies -- in this case, Community Health and its investors.
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Daniel Niemi at email@example.com