Those of us who watch Federal Reserve Chair Janet Yellen’s hearings before Congress will often hear complaints from the majority that the Dodd-Frank regulations are overreaching in that the Treasury has the power to designate non-bank financial entities, including mutual funds, as being systemically important. However, the recent collapse of the Third Avenue Focused Credit Fund, a junk bond fund focusing on the kind of distressed junk bonds that are one of my favorite asset classes, shows that an institution does not need to hold assets in the hundreds of billions of dollars in order to wreak havoc as it fails. This fund, which a year ago had only $3 billion in assets, was down to less than $800 million owing to losses and redemptions, was forced to suspend redemptions in order to liquidate in an orderly fashion, and its forced liquidation has spread shock waves through the entire high yield market, although they seem to have been contained.
I should state that I am generally a fan of additional financial regulation, and I am concerned that the complaining about designating nonbanks as systemically important is motivated by trying to force a wedge into a crack of Dodd-Frank with the goal of dismantling the entire law.
Anyway, the trouble here is that Third Avenue’s junk bond fund encountered arose from its ran afoul of one of a mutual fund’s main selling points, that the fund owners can redeem their investments at any time on one day’s notice, which, if many of them do at the same time, will require the fund to liquidate assets to raise the cash. In the case of most mutual funds (or in the case of markets being efficient), this is not a problem, but Third Avenue focuses on distressed bonds which are generally illiquid.
The causes for this illiquidity essentially boil down to the natural constituency of the asset class. Distressed debt, by definition, is corporate debt where default by the issuer is more than a theoretical possibility. The distressed debt marketplace, it seems to me, is a small and fairly specialized niche of the fixed income market, populated by some very price-conscious experts commonly described as “vultures.”
The ideal owner of distressed debt, then, is one who does not worry about cash flow interruptions, who has the analytical ability to compute what a company would look like and be worth after a restructuring or bankruptcy, and who is not a slavish observer of daily or quarterly price reports, since the price of these assets both fluctuate wildly and depart from true value. These characteristics would commonly be found in a private equity fund, in a hedge fund with limited redemption rights, or possibly in an endowment or in an eccentric millionaire. They would not normally be found in a typical mutual fund shareholder.
I think much of Third Avenue’s liquidation mess is the natural consequence of reaching for yield, climbing down the credit quality ladder until eventually one falls off the bottom rung. From a value investing perspective, it is what happens when buyers focus on the naive indicators of returns, like yields, rather than on true value. The wise investor would prefer a demonstrably undervalued asset with no yield than a demonstrably overvalued asset no matter how high the stated yield is. This lesson was pointed out originally by Benjamin Graham and reiterated in many places, especially The Only Guide to Alternative Investments You’ll Ever Need: As individual assets, junk bonds can be attractive, but as an asset class they are not.
This liquidity problem is compounded by the cascade of redemptions that Third Avenue has already experienced over its recent history. If the fund has to sell assets to meet redemption calls, and does not wish to give up too much in spreads in order to meet them, then logically it will sell its more liquid assets first and keep holding the less liquid ones, which will eventually leave it holding only illiquid assets and being forced into its present predicament.
Moving beyond the troubles of this particular fund, I am concerned about the issue of contagion. Contagion played a role in the financial crisis, as banks that sponsored synthetic mortgage backed securities products through special-purpose entities faced the distasteful choice of either propping up these entities by diverting money from their other lines of business like lending money to the real economy, or by letting these products be liquidated in a falling market, thus making the defects of these products obvious to the financial community as a whole. The parallels between these banks and what Focused Credit went through are obvious, and as with Focused Credit, the banks tried the first approach, and when it failed, were forced to try the latter.
Now, in an efficient market, the last reported price is the only true and correct price, forever and ever, amen, but the market seems to have been more or less aware of the situation and has managed to shrug it off. As a result of Focused Credit’s collapse, high yield ETFs declined by a total of nearly 3% on Monday and Tuesday of the week of the announcement, although they have staged a recovery. The New York Times claims to have identified the missing ingredient that separates the Third Avenue Focused Credit situation from the typical market crash: no leverage.
However, leverage as such is not the issue; any situation involving a forced sale can become a problem in the market. Excessive leverage is one source of forced sales, but the right of mutual fund owners to redeem their assets at any time is one source of leverage. An angry phone call from a boss or a client demanding to know what you’re doing holding these assets while they’re collapsing in value is another. And for that reason, any collapse in prices, no matter what the asset or leverage in question, is theoretically capable of setting off a contagion if it is severe enough.
As another window on this subject, I will look at it in terms of options theory. Ever since options were invented, people have been trying to put them into situations where they don’t entirely belong. For example, one model in the CFA curriculum is that a company that borrows money is short a put option on itself, with a strike price equal to the amount of borrowing. This model is somewhat complicated in that the option premium is difficult to define and the Chapter 11 bankruptcy process tends to complicate the payout method, but as Charlie Munger says, wise investors should be fluent in as many models of reality as as there are, in case one of them comes in handy one day.
At any rate, Focused Credit was effectively short a put option on its own assets, or specifically the liquidity spread between the price under “normal” conditions and the fire sale conditions that arise from having to sell on a day’s notice. Relatively illiquid assets like high yield bonds already trade with a liquidity discount intended to cover this gap, but as market conditions change, this liquidity premium can become inadequate. And unfortunately, there is no market instrument that tracks liquidity in a particular sector of the market, making hedging this risk impossible. Dynamic Hedging: Managing Vanilla and Exotic Options, the book Nassim Taleb wrote before becoming famous, is a lengthy text dealing with mathematics and financial philosophy, but its key lesson is that no market participant should ever be short an unhedged option, because sooner or later they will find themselves on the wrong end of the market.
The bitterest irony, though, is that in the case of Focused Credit, the counterparty of this liquidity option is the other holders of the mutual fund, who chose to exercise it by selling early before the crisis hit. Basic game theory requires an investor who is aware of a potential liquidity problem to get out as soon as the prospect of a liquidity crisis is raised; it is no different from standing near the exit of a building in case of fire. The decision by Focused Credit to suspend distributions and liquidate in an orderly fashion cut off this process, a move which was reasonable but almost unheard of in the mutual fund industry. But at any rate, investors who genuinely cannot be forced out of their positions can happily sit like a dragon and suck up a liquidity premium they never will need. Anyone else should avoid a situation where other people can sell out first and leave them holding the bag.