The Third Avenue Focused Credit Fund suspended redemptions on December 9, 2015, in conjunction with the announcement of a plan to close the struggling fund. Third Avenue, founded by legendary value investor Martin Whitman, formed a liquidating trust to sell the remaining assets of the fund over an extended period of time. It may be more than a year before the fund is fully liquidated.
The Focused Credit Fund had concentrated exposure to distressed investments, leaving it exposed to a liquidity crunch as investors fled the high-yield category. According to Bloomberg, the fund had fallen from $2.4 billion of assets earlier this year to less than $800 million of assets at the time of the liquidation announcement.
The failure of two Bear Stearns hedge funds in 2007 was a prelude to the financial crisis, providing early warning of the impending collapse of the subprime mortgage market. Investors are concerned about the failure of Third Avenue’s fund, fearful about the broader implications for the market. Activist investor Carl Icahn expressed his view about the Third Avenue situation, calling the high-yield market a “keg of dynamite” in an interview with CNBC.
Meanwhile, I’ve been binge-watching episodes of The Walking Dead, the television show about a zombie apocalypse — my daughter Emma’s favorite show. During the financial crisis, subprime mortgages became zombies that threatened to engulf the global financial system. Are high-yield corporate bonds the next zombie apocalypse jeopardizing the financial system, or does turmoil in the high-yield market create a buying opportunity?
Zombie Energy Companies
Energy companies face an existential crisis, contending with plummeting prices resulting from the fracking revolution and the virtual breakup of the OPEC cartel. In the words of one high-yield investor, “energy companies used the high-yield market as an ATM for years, now the bill is due.”
Some energy companies are already among the walking dead, with others to follow if energy prices stay at current levels. Commodities companies face similar challenges, facing the end of the “commodity super cycle” that was fueled by China’s industrialization.
Contagion from energy and commodities has spread into other areas of the high-yield and investment-grade bond markets, which is at least partially a function of the need for fund managers to raise cash for shareholder redemptions. However, the outlook for hig- yield bonds outside of energy and commodities may not be as dismal as recent market activity would indicate.
Fitch Ratings estimates that default rates will rise from 3.3% to 4.5% in the next year, far lower than the double-digit default rates projected for energy. The projected increase of non-energy defaults may be more indicative of a reversion to historical norms than to a return to broad-based collapse of credit markets experienced in 2008. Another perspective is provided in Chart 1 below, which shows that the BCA Research measure of corporate health has somewhat declined after several years of post-financial crisis improvement, but has not deteriorated to the level that would signal an impending crisis.
Are ETFs to Blame?
Icahn made recent comments highly critical of ETFs and of BlackRock in particular, saying that “BlackRock is an extremely dangerous company,” investors are heading over a cliff in a “party bus” driven by BlackRock and that there is no liquidity behind ETFs. BlackRock manages trillions of dollars, including the largest high-yield ETF, the Ishares iBoxx High Yield Corporate Bond ETF, making it an easy target for Icahn and other critics.
According to BlackRock, roughly 10% of the high-yield market trades every day, which can make it challenging for mutual funds and ETFs to calculate their net asset value. Some bonds may not trade for weeks at a time. For bonds that don’t trade in a given day, mutual funds and ETFs calculate their net asset value each day by examining prices for bonds that traded, evaluating overall market conditions, then estimating a market price for each bond that didn’t trade that day. That pricing process works surprisingly well under normal market conditions, but may break down during times of market distress.
In less liquid corners of the market, a correction can turn into a panic. In the “run on the bank” scenario experienced by Third Avenue, the fund sold its easier-to-trade, easier-to-value securities to cover the initial waves of shareholder redemptions.
As shareholders continued to flee the fund, Third Avenue was left with a more concentrated portfolio of distressed, hard-to-trade and hard-to-value securities. The bonds remaining in the fund probably can’t be sold immediately without a steep discount. Third Avenue’s assertion is that there is economic value remaining in the fund, and that given time for an orderly liquidation, the remaining bonds will trade at a price closer to their value. Time will tell whether this assertion will prove to be true.
Icahn’s criticisms of ETFs are countered by many proponents for the ETF structure. Net redemptions of mutual funds are “internalized” by the mutual fund, with the mutual fund paying departing shareholders out of cash on hand or by selling portfolio securities. The flood of shareholder redemptions forced Third Avenue to sell portfolio securities into a fragile market, creating something of a negative feedback loop for its portfolio.
ETF supporters argue that there are differences in the ETF structure that mitigate some of the liquidity challenges faced by mutual funds. Selling activity in bond ETFs is “externalized,” as smaller orders are matched at a market clearing price between buyers and sellers. Institutional investors known as authorized participants are the only investors allowed to redeem an ETF at net asset value, and those redemptions are typically paid in kind with the seller receiving a pro rata portion of the bonds owned by the ETF.
I think the ETF structure to some degree reduces the forced selling of underlying fund holdings, and creates less of a potential conflict or imbalance between “first movers” out of a product and later movers.
Icahn’s comments make for great soundbites, but don’t always hold up under closer scrutiny. However, I do think that the marketing of ETFs has contributed to investor complacency about the risks of investing in less liquid areas of the market, including high yield, leveraged loans, emerging markets debt and frontier markets equity.
The ease of trading ETFs fosters an impulse to tactically trade less liquid parts of the market that aren’t well suited for rapid-fire trading.
So What to Do?
“In the short term, the market is a popularity contest. In the long term, the market is a weighing machine.”
This timeless quote from Warren Buffett is a good illustration of the approach he takes to investing, and is a reminder of the opportunities that present themselves when market volatility increases. During the financial crisis, forced sellers bore the most pain. Investors with a long-term time horizon, limited liquidity needs and conviction supported by thorough analysis snapped up bargains among better positioned financial stocks, mortgage, and real estate in the San Francisco Bay area and other desirable locations.
Energy is still a dangerous part of the market.
It may be too early for all but the most intrepid and well-informed investors to bottom fish among troubled energy companies. Low energy prices may persist for an extended period of time, with politics and military action in the Middle East making financial projections difficult to pin down. Zombie companies may also distort the energy sector, which could extend the necessary adjustment process.
High-yield index ETFs may not be the best solution for investors wanting to invest in high-yield bonds.
High-yield index ETFs such as the iShares iBoxx High Yield Corporate Bond ETF (HYG) have significant exposure to energy bonds (11.23% as of 12/14/2015) that are major constituents in the indexes that ETFs are designed to track. Investors may prefer actively managed solutions in which credit analysts determine what to own and what to avoid.