Junk bonds, and the funds that invest in them, may actually be as safe as their name implies.
Earlier this year, Carl Icahn warned that individual investors were piling into junk bond funds without realizing the risk that they might not be able to get out. The risk has now been realized, though it is small for now.
Mutual fund company Third Avenue said it was taking the unusual step of blocking investors from getting their money out of the Third Avenue Focused Credit fund. The fund, which was heavily invested in some of the lowest rated junk bonds, has just under $800 million in assets. That was down from about $2 billion in assets at the beginning of the year. Third Avenue said it was winding down the fund because it didn’t have the cash to meet all the redemption demands of its investors, and that the bonds it had had become hard to sell. Third Avenue said it would distribute a small portion of the money in the fund next week. But most of the money in the fund was being put into a trust, which may take as long as a year to liquidate.
The fund offered a concrete example to people who have warned for months that the ability to buy and sell bonds, so-called bond market liquidity, has been diminished since the financial crisis. Some people have blamed regulations that limit the banks’ ability to hold certain types of bonds. Meanwhile, numerous Federal Reserve studies have found that liquidity in the bond market has not dropped.
The Third Avenue fund that has run into trouble was in a particularly risky corner of the bond market. The biggest holding in the fund are the bonds of iHeartCommunications, formerly Clear Chanel Communications, which have fallen 54% since June, according to Bloomberg. Overall, the fund was down 27% this year.
The junk bond market has already been under stress. So the problems that Third Avenue has may be more about the risky bonds it bought into and not an overall problem in the bond market. And the fact that the fund was in a specific corner of the market and is taking a year to wind down, rather than continuing to dump its holdings to satisfy redemptions, could limit the damage it will cause.
Still, the worry is that problems with the Third Avenue fund would cause other individual investors to try to flee other junk bond funds. Most junk bonds funds are down this year. and there are a handful that were down in the double digits, according to Morningstar. On Friday morning, the Barclay’s SDPR High Yield Bond exchange traded fund dropped 1%. The ETF is down nearly 12% in 2015. That was down much more than junk bond prices in general, which have only fallen 3%, suggesting that fear selling in the junk bond market may be in full swing.