Third Avenue Focused Credit Fund Collapse May Create Bond ETF Problems

Third Avenue Management has frozen redemptions (withdrawals) from its high-yield (junk) bond fund. Some market experts have opined that this may be an early warning signal for bond exchange-traded funds (ETFs), as concerns in the bond markets may lead to a massive rush to sell bond holdings. Some market watchers have long feared that any kind of rush of investor selling would expose a major flaw in the ETF design.

Some believe that bond ETFs are more vulnerable than bond mutual funds because bond mutual funds have active fund managers who analyze what to sell and what to hold, whereas a bond ETF merely tracks an index without any analysis involved in determined that to sell or hold.

The Third Avenue Focused Credit Fund (TFCVX) announced it was shutting down, but that investors might have to wait months for their money. In response, trading in the the high-yield bond market increased as investors scrambled to adjust their bond portfolios. Both the SPDR Barclays High Yield Bond ETF (JNK) and the iShares iBoxx High Yield Corporate Bond ETF (HYG) saw their trading volume spike to three times their average daily levels as the market reacted to indications of trouble in the junk bond market.

The lowest quality high-yield (junk) debt, which currently represents about 10% of the high-yield bond market, is down more than 40% over the past 18 months. Many of the struggling bonds are tied to struggling energy-related industries. The recently closed Third Avenue fund was very aggressive and risky, as it had an estimated 28% of its assets in the lowest-rated junk bonds rated triple-C or lower. This was nearly three times the average allocation of other bond funds.

So far, no other bond funds have blocked investor redemptions, but a junk-bond hedge fund, Stone Lion Capital, announced it was suspending redemptions.

Junk bond investors could suffer significant losses if panic selling depresses prices dramatically.

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