The blow-up of Third Avenue Management's junk bond fund this week, the biggest mutual fund failure since the financial crisis, show the dangers of loading up on risky assets that are hard to trade even in good times.
At least one-fifth of Third Avenue's Focused Credit Fund, with less than $1 billion under management, was composed of illiquid assets, meaning they trade so infrequently that they don't have a market price, according to a Reuters analysis. That's one of the highest percentages of exposure in the junk bond sector.
Meanwhile, some of the most popular U.S. junk bond funds also have made large bets on assets considered the hardest to trade and value in the industry, and their portfolios may not reflect the full extent of the current downturn in the junk bond market, said junk-bond analyst Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC.
"Precisely because these (assets) are hard to price, they won't necessarily show the full extent of the market decline," Fridson said. "That can make a fund with lots of illiquid security look better than a fund with big, liquid names where the price declines are very transparent."
AllianceBernstein's AB High Income Fund has the biggest holdings on a percentage basis this year among the largest junk bond funds. At the end of July, the fund reported $1.08 billion in illiquid assets, or 15 percent of the securities in a $7.3 billion portfolio, according to a Reuters analysis of the 10 largest U.S. junk bond funds. The Third Avenue fund isn't in the top ten.
AllianceBernstein did not respond to questions seeking comment.
With the $236 billion junk bond mutual fund sector on course for its worst performance in seven years due to a rout in commodity prices and expectations of higher interest rates, some big junk bond funds already are scaling back exposure to their riskiest assets.
The $17 billion American Funds High-Income Trust Fund , which this year realized nearly $200 million in losses on its most illiquid assets, told Reuters it plans to reduce its current exposure of 1.6 percent of securities that are hard to price and trade.
An American Funds spokesperson said the positions are carefully researched.
High yield, also known as junk, debt issuance has skyrocketed from $147 billion in 2009 to more than $300 billion in each of the last three years. Record-low interest rates have encouraged investors to take on more risk, including the debt of less creditworthy issuers, to get a higher return.
Tom Lapointe, portfolio manager of the Third Avenue fund, said in an October 2014 interview with Reuters that "any company with a pulse has been able to refinance."
In addition to AllianceBernstein and American Funds, other investment funds such as BlackRock Inc and Waddell & Reed Financial Inc have junk bond funds - staple holdings for pension funds, retirement plans and mom-and-pop investors - that hold the largest amount of assets that are so illiquid and so hard to price that their valuations are sometimes pegged to assumptions made by the investment managers themselves, their fund disclosures show.
The illiquid debt favored by junk bond funds ranges from subprime loans bundled into mortgage-backed bonds by Wall Street banks on the eve of the credit crisis to bank loans to distressed companies in the energy and chemical industries.
Fund managers favor illiquid assets because they may pay 50 cents on the dollar to buy them, for example, and they get a yield premium for carrying the extra risk, said Sumit Desai, an analyst at fund research firm Morningstar Inc.
Most junk bond funds don't hold any so-called Level 3 assets, which are generally considered risky and illiquid, or the amounts are less than 1 percent of their portfolios, according to a Reuters analysis of fund disclosures.
Junk bond portfolio managers already are navigating a treacherous market featuring a meltdown in the energy sector. Managers say junk-bond pricing volatility is reminiscent of the 2008 financial crisis. And investors have made $5.7 billion in net withdrawals from junk bond mutual funds this year, according to data from Lipper Inc, a unit of Thomson Reuters.
DoubleLine Capital bond star Jeffrey Gundlach this week predicted "real carnage" in the junk bond market as the Federal Reserve leans toward raising interest rates for the first time in nearly a decade.
The sector is losing 3.01 percent this year, compared with 2008 when junk funds lost 25.5 percent, according to Lipper Inc data.
Fund assets are typically categorized as Level 3, according to U.S. accounting rules, when pricing is unavailable and their value is set by internal estimates or quotes from outside vendors. By contrast, U.S. government bonds or blue-chip stocks are categorized as more liquid Level 1 assets because their value is easily discovered in the market and they trade frequently.
Some funds with the highest percentage of Level 3 assets also are among the worst performers, according to Lipper.
Waddell & Reed's $6.7 billion Ivy High Income Fund ranked fifth worst with a one-month total return of negative 3.33 percent. The fund's Level 3 assets were almost $260 million at the end of September, or 4 percent of the portfolio. The company did not return messages seeking comment.
BlackRock declined to comment about its holdings.
"For stuff that's illiquid even under ordinary conditions, anyone who sells under present conditions will take a bath," Fridson said.
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