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Summary Third Avenue Focused Credit Fund has been placed in liquidation by its board of trustees. The cause was the illiquidity of its portfolio of deep value high yield securities. The board could not continue to run an open-end mutual fund with such a high concentration of illiquid securities. Will there be contagion for other high yield bond funds? Yes, if they have a high proportion of illiquid securities in their portfolios. On December 10, Third Avenue Focused Credit Fund (MUTF: TFCIX ) announced that it was going into liquidation rather than redeeming any additional securities. It is in all the newspapers. Liquidation is a highly unusual move for an open-end mutual fund to make, but it appears to have been the only rational course of action open to the fund’s board of trustees in the circumstances. The fund, started in 2009, had an unusual, possibly unique investment style. It invested in deep value high-yield bonds – the sort that would not blush when called “junk” – often with the lowest ratings. Third Avenue Management, the fund’s manager, and its chairman, Martin Whitman, are highly regarded value investors. It is not a fly-by-night operation. Indeed, when the Focused Credit Fund opened in 2009, I was an early investor – though I redeemed my shares after about a year because I thought the fund was taking greater risks than I had understood when I invested. The fund had over $2 billion of assets at the beginning of 2015, but due to portfolio losses and redemptions, it was down to $789 million at December 10. Illiquidity of the Portfolio Assets of a mutual fund have two pricing mandates: (1) a mandate under the Investment Company Act that, although detailed in overall methodology, is relatively general regarding specific securities, and (2) a process under Generally Accepted Accounting Principles, which, by dividing valuation into three methodologies, is somewhat more specific. By reason of its specificity, the GAAP definition tends to prevail in the valuation of individual securities. The last SEC-filed report on the valuation of the Focused Credit Fund’s portfolio securities, as of 7/31/15, shows that of the fund’s $1,953 million of assets, $171 million was priced in accordance with level 1 methodology, $1,399 million in accordance with level 2 methodology, and $382 million under level 3 standards. By the standards of most mutual funds, only level 1 assets are deemed to be liquid – that is, capable of being sold at a price near their valuation in a reasonable period of time. The Third Avenue Focused Credit Fund had over half its assets in level 2 and almost 20% in level 3, which sometimes is called “mark to myth.” These figures stand out starkly against the SEC’s general rule that open-end funds are to limit their holdings of illiquid securities to 15% of assets or less. Strategic Illiquidity Looking at Focused Credit Fund’s holdings, it appears that the deep value methodology that the fund adopted almost necessarily led to endemic illiquidity because securities of that type trade infrequently. Looked at in that light, the fund was almost bound to implode if the lowest-rated part of the high yield market declined significantly. And that is just what happened in 2015: The lowest rated high-yield securities performed far worse than the rest of the market. In that circumstance, a high level of redemptions was predictable, and an inability to sell the portfolio’s securities at reasonable prices in reasonable amounts of time also was predictable. Under and Over Valuations – Risks either Way In a way, I am surprised that the Board of Trustees waited so long to put the fund into liquidation because the responsibility for valuing level 2 and level 3 assets falls on the board itself, including its independent members. Although the board usually defers to management and often has a subcommittee that deals with valuations, the board as a whole is responsible. Thus, for a long period of time, the board has been blessing portfolio valuations that are hard to defend, even if they were done in the best of faith. Moreover, those who cashed out and those who held on had conflicting interests. Those who cashed out benefited from higher valuations; those who held on benefited from lower valuations. The board therefore has been or will be sued every which way. Liquidation is the only way to avoid further litigation risk for valuations. It appears from reading press reports that the officers of Third Avenue Management are concerned that they may have overvalued some portfolio securities. That surprised me because looked at from the point of view of a lawyer representing the independent trustees, a role I played often over a 30-year period, and the valuations should be conservative – on the low side. But it appears that the Third Avenue people are concerned about over-valuations. However, I now see that an investment manager has incentives to place valuations of the high side because that will keep the NAV up, which will tend to fewer redemptions and higher management fees. If the valuations were high, then stockholders that did not redeem may have been injured because stockholders that redeemed got more than they should have. In all likelihood, the remaining stockholders have a good class action. The board finally decided it had to liquidate the fund because no matter what valuation methodology it used, it would be subject second-guessing in court. Definition of Liquid Security Over the last year, I have written about the need for a better definition of liquid security. The definition, I have argued, is too loose; therefore, it is likely to lead to some funds holding far greater proportions of illiquid securities than the SEC thought safe – or than I thought safe. The industry has fought a redefinition because it has made money from the old definition. The liabilities that are likely to flow from this event may soften that opposition, and the events will strengthen the forces of reform. Here is what I said on this subject at NexChange.com about six months ago: The genius of the form is that forward pricing at net asset value prevents investors from gaming the system. Whether the market is going up or down, NAV is NAV. (Yes, there are issues with trading in different time zones, but those issues have been minor in most cases.) But the genius of NAV depends on two things: One, that it be a reliable source of true value; and two, that the underlying securities be, for the most part, liquid in substantially all markets. Many open-end bond funds have significant percentages of assets that are liquid under the SEC’s definition of “liquid” but that in a crisis would not be liquid-that is, they could not be sold except at a price far lower than their intrinsic value. If, due to redemptions, some funds were forced to sell such assets, the NAV of all similar funds would fall more precipitously than the intrinsic value of their underlying assets would warrant. This illiquidity problem could be solved by the SEC changing its definition of “liquid asset” to make it more stringent. Open-end bond funds then would have to avoid smaller issues that would likely be thinly traded and have practically no market in a crisis. But that will not happen because the fund industry is making too much money on their bond fund products. Besides, the problem is not likely to have a systemic impact because the illiquid issues are not due immediately and the losses that investors suffer will not, for the most part, be leveraged.” The liquidation of Third Avenue Focused Fund is evidence that my fears were well founded. In the same series of articles at NexChange, I discussed the difference between interest rate risk-based valuation issues and credit quality-based valuation issues. Here is what I said. It is applicable to the Focused Credit Fund style and experience. There is a big difference between wondering whether the interest rate on a particular bond is appropriate in the current market and wondering whether the bond will be repaid. The interest rate question an investor can quantify. At any given rate (the current risk free rate is known), the value, based solely on the interest rate, tenor and repayment options, is known. The spread between the implied market rate on the bond and the market rate on a similar duration Treasury reflects the market’s judgment as to credit risk. Traders will be quick to spot any anomalies and will take advantage of them, in effect stabilizing the interest rate side of the market. But when the issuer’s ability to repay comes into doubt, no one knows what the right price is, and the market may have no floor. That is what owners of sub-prime backed RMBS and their derivatives discovered on 2008. When credit quality is unknown, there may be no market price because there may be no market.” Contagion Will there be contagion for funds that look like Third Avenue Focused Credit Fund? Yes, if they really do look like it. But I expect there are not many of those. The unusual deep value nature of the fund’s strategy met up with that class of assets falling out of favor over the last year and seeing their value drop sharply. The bigger question is whether more ordinary high-yield open-end funds will suffer from contagion. First reactions, including that of the Wall Street Journal, appear to suggest there will be contagion throughout that class of funds. How far it will go remains to be seen. The tide has gone out. Now we will see who is swimming naked – that is, who really has a higher level of illiquid securities than they claim to have. That could be quite a few. According to research using the Schwab search engine, there are 82 high yield bond funds with over $500 million in assets, 28 with over $1 billion, and 3 with over $10 billion. That looks like maybe $48 billion of assets. That is a large number, but it does not seem like enough to be a systemic threat. (Yes, that’s what they said about the subprime mortgage market in 2007.) Two of the biggest are BlackRock High Yield Fund (MUTF: BHYAX ), and JPMorgan’s High Yield fund (MUTF: OHYFX ). Scalper1 News
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