Third Avenue Management's abrupt freezing of investor redemptions from its high-yield bond fund may be an early warning signal for bond exchange-traded funds.
Investment strategists say that Third Avenue's troubles may be the latest test for bond ETFs, which trade throughout the day like individual stocks, and are more liquid than their underlying assets. Some market watchers have long feared that any kind of rush of investor selling would expose a major flaw in the ETF design.
“This is a point I've been making for a long time, because this is a much bigger problem for ETFs than it is for mutual funds,” said Bob Rice, chief investment strategist at Tangent Capital.
“We're talking about a huge wheat-and-chaff moment, and you'll want to be behind a bond manager who is making intelligent decisions right now about which bonds to hold,” he said. “That's why bond ETFs bother me, because [as index-trackers] they're not doing any analysis about which bonds to hold, which is not the way to invest in a market like this.”
TRADING VOLUME SPIKES
Last week when the
Third Avenue Focused Credit Fund (TFCVX) announced it was shutting down, but that investors might have to wait months for their money, the high-yield bond market kicked into high gear, as illustrated by increased trading of the two most liquid high-yield bond ETFs.
Both the SPDR Barclays High Yield Bond ETF (JNK) and the iShares iBoxx High Yield Corporate Bond ETF (HYG) saw their trading volume spike to three times average daily levels as the market reacted to indications that some corners of the junk bond market are in trouble.
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LIQUIDITY CONCERNS?
Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, said he believes ETFs passed the initial test, even though some sellers may have lost money through panicked selling.
“I don't think there's a liquidity problem with ETFs, because as long as there are buyers for the ETFs, the ETFs won't have to sell the underlying bonds so quickly,” he said, citing the fact that on Friday the JNK and HYG ETFs were traded at 17 times the rate of the underlying securities in those ETFs.
“There are buyers out there, as we saw last week,” he said. “I actually think seeing something like Third Avenue blocking investor redemptions will drive more investors toward ETFs, because when they need to get out they know they can and they know the price.”
Meanwhile, the full effect on the bond market of Third Avenue's unusual exit strategy remains an unknown, according to Gary Pzegeo, head of fixed income at Atlantic Trust Private Wealth Management.
“Everyone is asking the same questions right now, because it's normal to worry about some kind of contagion with something like this,” he said.
Even though Third Avenue's strategy might have shocked the bond markets, the
events leading up to the fund's sudden liquidation was not a surprise to bond market insiders.
LOWEST QUALITY
The lowest quality high-yield debt, which currently represents about 10% of the high-yield bond market, is down more than 40% over the past 18 months. The decline is in stride with the challenges facing the broader commodity complex, because much of the lower-quality debt is tied to struggling energy-related industries.
“The market has seen the prices move, and the reasons for those moves have been known by the market for a while,” Mr. Pzegeo said. “The question is, are there managers who own some distressed debt and how is it affecting their performance?”
The Third Avenue fund was an outlier with an estimated 28% allocation to bonds that were rated triple-C or lower. At nearly three times the average allocation to the same low-quality debt, Third Avenue was making an aggressive push for yield.
Part of the contagion that Mr. Pzegeo and others are worried about is investors seeing any distressed debt in their bond funds and fleeing in response. If that starts to happen, fund managers might have to quickly sell higher-quality, more-liquid bonds, which could spread rapidly throughout the bond market.
“We don't know yet if bond funds will see some reaction from investors, or how those bond fund managers will respond,” Mr. Pzegeo said. “If they can't sell their distressed debt, and they have to sell something more liquid, that's the contagion, and that's the part yet to be seen.”
2008 REDUX?
So far, no other bond funds have tried to block investor redemptions, but last week a
junk-bond hedge fund, Stone Lion Capital, did announce it was suspending redemptions.
“Everyone who's involved in the high-yield market has some degree of distressed debt in their portfolio,” said K.C. Nelson, portfolio manager and head of alternative strategies at Driehaus Capital Management. “The fallout from here is the $60,000 question.”
In addition to the standard high-yield bond risks related to interest rates, credit quality and liquidity, the market is dealing with typical year-end reduced-liquidity issues, tax-loss harvesting and what is expected to be the
Fed's first interest rate hike in nearly a decade.
“Whether or not this spreads depends on the next four-to-six weeks, because a lot of investors could read the headlines and think it is 2008 all over again,” Mr. Nelson said. “But the reality is, there's nothing that has happened to the fundamental credit worthiness of these companies issuing the distressed debt from last week to now.”
