After peaking way back in 2014 and declining ever since, the high yield (junk) bond market has finally made national news over the past week with the very high profile blow up of the Third Avenue Focused Credit Fund (TAFCF). This was not some fly by night little fund or fund family. It’s a small, mainstream mutual fund family and the fund itself had more than $3 billion in assets in 2014. Last week, after massive withdrawals, the fund announced it was closing and that shareholders could not redeem their shares for cash anytime soon. Third Avenue was going to conduct an “orderly” liquidation. Good luck with that!
Over the past 20 years, my peers and I have often discussed this is exact scenario. What happens when there is a mass exodus in an illiquid asset class like junk bonds? If Third Avenue was a closed end fund (CEF) or exchange traded fund (ETF), sellers would simply drive the price lower and lower until sufficient buyers came in, presumably when the share price of the CEF or ETF was significantly below the value of the underlying assets in the fund. In other words, the CEF or ETF would trade at a discount to the net asset value of the fund.
In Third Avenue’s case, it is an open ended fund that issues more and more shares to meet investor demand. When redemptions swell, the manager chooses what to sell and when. And it’s unlikely that securities are sold on a pro rata basis. As TAFCF’s assets collapsed, my sense is that the fund manager sold most or all of the bonds that were easier to sell, i.e., liquid, hoping that he could stem the tide and high yield bonds would stabilize or even bounce. When the liquidations never ceased, the fund was probably left with the true crap of crap instead of the well diversified portfolio it had weeks, months or quarters earlier. In other words, at the detriment of the shareholders who stuck by the fund, they were left with illiquid garbage.
This raises a whole series of questions regarding the fund manager’s and fund company’s fiduciary responsibility to its shareholders. Clearly, they had absolutely no plan for a mass exodus, like disaster planning for many firms in my space. How could they allow the fund manager to sell the better quality bonds and turn the fund into a heap of crap? How could they penalize investors like this? While I am sure they will hide behind the nonsensical legalese of the prospectus, this is a travesty!
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