Fund Blow Up

For junk bonds, 2015 may be a year best forgotten. Returns this year are abysmal by virtually any measure.

It's so bad that some junk-bond funds are blowing up. Most recently, Third Avenue made waves when it announced its decision to liquidate one of its funds and barred investors from withdrawing their capital

Third Avenue's Focused Credit Fund (NASDAQMUTFUND:TFCIX) lost 27% for the year, significantly worse than that of popular junk-bond ETFs SPDR Barclays High Yield Bond ETF (NYSEMKT:JNK) and iShares iBoxx $High Yield Corporate Bond ETF (NYSEMKT:HYG), which lost 8.2% and 6.8% year to date, respectively.

You shouldn't panic. Third Avenue's Focused Credit Fund is just one of hundreds of funds. But it won't be the last junk-bond fund to go belly-up. Rather than dismiss it as an anomaly, investors should see this as an opportunity to do a post-mortem. What, exactly, pushed its Focused Credit Fund to the brink? Does your fund face similar blow-up risk?

Is your bond fund next?
Bad funds rarely collapse because of performance alone. Often, bad performance begets redemption requests from investors, forcing a fund to sell already stressed assets at lower and lower prices. The result is a downward spiral of fund redemptions and forced sales. 

It doesn't help that stressed funds become the talk of the Street. The Wall Street Journal interviewed one trader who was betting against Third Avenue's holdings, knowing that a liquidation would drive down the value of the bonds it held in its portfolio. 

How can you tell which funds can handle redemption requests and which can't? Here's a simple stress test.

Your fund is required to classify its investments into "levels," 1 to 3. Level 1 assets are the most liquid. Level 3 are the least liquid. Funds that hold more Level 1 and 2 assets and fewer Level 3 assets are in better position to meet redemption requests in an orderly fashion.

When Third Avenue's Focused Credit Fund last reported its holdings in an N-Q filing with the SEC, it disclosed that 19.6% of its assets were Level 3 assets. Level 3 assets are investments where there is no liquid market to determine their worth.

In other words, Third Avenue took investment capital that could be withdrawn within days and invested a hefty chunk (nearly 20% of it) into investments that couldn't be sold with any particular urgency. That's a problem -- a twist to the classic case of an asset-liability mismatch.

As Third Avenue's assets declined, it sold the most liquid of its investments to meet redemption requests. Thus, it became a more concentrated bet on illiquid assets at a time it needed to be very liquid -- a time when investors were pulling cash out of the fund. Level 3 securities jumped from 9.2% to 19.6% of its assets from July 2014 to July 2015.

Does your fund face the same risk? The answer is in its filings and reports most investors receive by snail mail but often throw away. A quick way to test for this issue is to see what percentage of a fund's assets are Level 3. Mutual funds should have little to zero Level 3 assets, given that Level 3 assets are not liquid by definition.

Testing for quality
If there is any lesson investors learned during the financial crisis, it's that credit ratings aren't perfect measures of risk for any one investment. But credit ratings exist because, on average, they are very good at predicting the probability of default, and how much an investor will lose if a company defaults on its debt.

One of the best ways to see the underlying credit quality of a fund is to look to the fund's website, annual reports, or a free data service such as Morningstar. And Morningstar reports that Third Avenue's fund had 47.8% of its assets invested in junk bonds with a rating of below B. Another 41.2% of investments weren't rated.

By contrast, Barclays' junk-bond ETF had only 14.6% of its assets invested in credits rated below B, and zero investments that weren't rated.

The lower the credit quality, the more volatile performance will be. When junk bonds sell off, the lowest-rated bonds are typically hit hardest. Likewise, the riskiest bonds typically rise fastest in a bull market. Investments that don't have a credit rating are typically the most volatile and least liquid, a double whammy.

These two simple tests can help you do a very quick-and-dirty stress test of your junk-bond fund. In less than 15 minutes, you can find how exposed your fund is to less-liquid Level 3 assets and higher-risk below-B and unrated bonds.

Doing a little homework may help you avoid a fund that's taking far too much risk for a little extra yield.

 

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.