The Accidental Distressed Debt Fundby
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.
"Ownership of distressed bonds ... by ordinary high-yield mutual funds is usually inadvertent," Marty Fridson, chief investment officers at Lehmann LivianFridson Advisors LLC, writes in a blog post. "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."
The increasing tendency of high-yield bonds to trade like distressed credits is a reversal of a seven-year trend that has seen investors slide down the credit curve in a dramatic search for yield, helping to push risk premiums on junk bonds to levels previously seen on investment-grade debt sold by companies with stronger balance sheets. Spreads on investment-grade debt, meanwhile, have also compressed to historic lows.
For its part, Third Avenue's credit fund held more than three quarters of its $788 million of assets in CCC- and lower-rated debt, with a substantial chunk in bonds lacking credit ratings of any sort, and 28 percent of its total portfolio concentrated in its top 10 positions. In the words of Federal Reserve Chair Janet Yellen, Third Avenue was a "rather unusual open-end mutual fund" with "very concentrated positions in especially risky and illiquid bonds"—hardly representative of a typical high-yield bond fund.
But further stress in high-yield land has the potential to impact a broader selection of bond managers.
"High-yield mutual fund shareholders should certainly take a close look at this simple metric for their own funds," Fridson says, referring to Third Avenue's holdings of lower-rated debt. "A ratio approaching Third Avenue Focused Credit Fund's would be a strong indication that the fund is in reality a distressed debt player, regardless of how it is classified by [U.S. Securities and Exchange Commission] rules."
Third Avenue was a distressed debt fund that acted a lot like a high-yield bond mutual fund. The question now is whether genuine high-yield bond fund managers may find themselves reluctantly thrust into the role of distressed debt managers at a time when such debt is becoming increasingly difficult to sell. Even as junk bonds rallied over the past few days, the riskiest (and historically the fastest growing) portion of the market, has been left behind, with the risk premiums of CCC-rated debt compared to less risky bonds, still on the rise.
It doesn't augur well.