The Collapse of the Third Avenue Junk Bond Fund
February 17, 2016
The Collapse of the Third Avenue Junk Bond Fund
Mutual funds pool money from various investors and act as
fund managers are liquidating the fund’s remaining assets,
financial intermediaries to invest those proceeds in
which is likely to be a protracted process widely predicted
securities, such as corporate equity or various types of
to last many months. Some question whether the fund’s
bonds. Led by fund managers, the funds attempt to generate
shareholders, who include individual investors, nonprofit
capital gains and income for their investors who are
concerns, and pension funds, will ultimately be made whole
typically given the right to redeem their fund holdings on a
with respect to the value of their remaining holdings on
daily basis. In 2014, according to the Investment Company
December 10, 2015, the advent of the redemption freeze.
Institute, a fund trade group, the roughly 9,000 domestic
funds held about $16 trillion in assets.
The Regulation of Mutual Funds
In early December 2015, Third Avenue Management, a
The SEC primarily regulates mutual funds such as the Third
company that manages several mutual funds, announced
Avenue fund through the Investment Company Act of 1940
that it was freezing shareholder redemptions and
(P.L. 76-768). As described by the agency, the act
involuntarily liquidating the assets of a financially troubled
member of its mutual fund family, Third Avenue Focused
[I]s designed to minimize conflicts of interest that
Credit Fund (the Third Avenue fund). Launched in 2009,
arise in these complex operations. It requires these
the Third Avenue fund was principally invested in high-
companies to disclose their financial condition and
yield or junk bonds, debt issued by companies with a
investment policies to investors … [It also requires]
relatively high risk of default (when a debt issuer is unable
disclosure to the investing public of information
to make required payments on its debt obligations).
about the fund and its investment objectives, as well
as on investment company structure and operations.
This collapse was the first by a domestic mutual fund since
the failure of the Reserve Primary money market fund (such
Figure 1. Total Net Assets of Mutual Bond Funds by
funds primarily invest in short-term debt) during the 2008
Investment Objective, Year End 2014 (in $ billions)
financial crisis. The potential broader systemic implications
of the mutual fund’s failure led the Treasury Department to
adopt a temporary money market fund shareholder
guarantee and the Securities and Exchange Commission
(SEC) to adopt a series of new money market fund
regulations. The Third Avenue fund, which had $790
million in assets on December 8, 2015, is being investigated
by the Massachusetts Securities Division and the SEC, the
primary fund regulator.
Source: Data from the Investment Company Institute.
The fund paid out all shareholder redemption requests
High-Yield Bonds
through December 8, right before fund officials closed the
fund and prohibited further redemptions. It then transferred
Investment grade debt is debt that a bond rating agency,
all of its invested assets into a liquidating trust, which
such as Standard & Poor’s or Moody’s, determines has a
issued fund trust interests to be distributed to the terminated
relatively low risk of being defaulted on by an issuer, such
fund’s shareholders. Fund officials said that the redemption
as a corporation or a municipality. As reflected in the axiom
freeze was necessary to avoid liquidating its assets in a fire
that potential return rises with an increase in risk,
sale. The move was characterized by various industry
investment grade debt is associated with relatively low
observers as rather unorthodox: SEC permission is
yields or interest payments.
generally required before fund redemptions can be frozen.
Later, on December 16, Third Avenue fund officials
By contrast, the Third Avenue fund was largely invested in
requested from the SEC exemptive relief for its earlier
long-term debt (i.e., maturities longer than 12 months) with
suspension of fund redemptions, and relief was obtained on
high-yield or junk ratings from bond rating agencies. As
that day. As part of the exemptive relief granted by the
described by the SEC,
SEC, the fund was allowed to shift assets from the trust
back into the fund while continuing to bar shareholder
A high-yield corporate bond is a type of corporate
redemptions. The fund’s investors will receive updated,
bond that offers a higher rate of interest because of
daily net asset value (i.e., a fund’s per share value as
its higher risk of default. When companies with a
reflected in the valuation of its assets) reports on their fund
greater estimated default risk issue bonds, they may
holdings. Investors were also paid an initial distribution of
be unable to obtain than investment-grade bond
about 9% of the total value of their holdings. Meanwhile,
credit rating. As a result, they typically issue bonds
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The Collapse of the Third Avenue Junk Bond Fund
with higher interest rates in order to entice investors
At the end of July 2015, the Third Avenue fund disclosed
and compensate them for this higher risk. High-
that Level 3 assets accounted for 20% of its total holdings.
yield bond issuers may be companies characterized
By contrast, most junk bond funds reportedly held no Level
as highly leveraged or those experiencing financial
3 assets. In addition, that 20% figure also exceeded the
difficulties. Smaller or emerging companies may
proportion of Level 3 assets reportedly held by other large
also have to issue high-yield bonds to offset
junk bond funds with portfolios in excess of $500 million.
unproven operating histories or because their
In early 2015, analysts at Citigroup reported that 76% of the
fund’s portf
financial plans may be considered speculative or
olio carried a Standard & Poor’s rating of
risky.
CCC+ or below. (The CCC+ rating occupies the middle
range of the various junk bond rating categories.) The
Over the past few years, various commodities-based
median for junk bond funds said to have certain similarities
companies in energy, metals, and mining funded through
to the Third Avenue fund reportedly was 22%.
the estimated $1.2 trillion high-yield debt market faced
significant commodity price declines. In return for the
Echoing this notion of the fund’s uniqueness, Federal
added risk, investors have reportedly demanded even higher
Reserve Board Chair Janet Yellen observed that the Third
yields on the junk bonds issued by such firms. Indices that
Avenue fund’s problems seemed atypical as it “had many
track the difference between overall junk bond yields and
concentrated positions and especially risky and illiquid
those from U.S. Treasury bonds, benchmarks of investment
bonds.” Still, there are some concerns that other junk bond
safety, indicate that in the fall of 2015, those yield
funds could face liquidity mismatches with the potential for
differentials were the highest that they had been in more
ensuing shareholder runs. A liquidity mismatch occurs
than three years. Bloomberg reported that for every high-
when a fund with relatively illiquid assets is funded by
yield bond issuer that saw boosted bond ratings in 2015,
investors who can make daily fund redemptions, as is
two issuers experienced rating downgrades, a ratio that
typical with mutual funds. For example, Marty Fridson,
reportedly had not been observed since 2009. Meanwhile,
chief investment officer at Lehmann Livian Fridson
according to some analysts, including Matthew Mish of
Advisors, observed that some bigger junk bond funds have
UBS Investment Bank, the initial stress felt by high-yield
large amounts of the industry’s most illiquid and hardest to
issuers in the commodities sectors appears to have “spilled
value assets and may have valuations that do not fully
over” into “the broader high-yield market.”
reflect the junk bond market downturn.
High-Yield Bond Funds
Recent Related Regulatory Developments
In the low interest rate environment of 2009, investors
Citing the Third Avenue fund’s example, a late 2015 report
began pouring tens of billions of dollars into higher
aimed at highlighting “key potential threats to U.S.
yielding junk bond funds. The Investment Company
financial stability,” from the Treasury Department’s Office
Institute, reports that total net assets of high-yield bond
of Financial Research observed that mutual funds could
funds grew from $118 billion in 2008 to $198 billion in
problematically “increase the liquidity mismatch in the
2009, then advanced to $420 billion by 2013. Later,
corporate bond market because these funds may not be able
however, amidst the aforementioned junk bond market
to liquidate their investments as investments as quickly as
doldrums, junk bond fund investors withdrew more money
their shareholders can withdraw capital, presenting
than they invested in those funds (i.e., net outflows) in both
redemption risk for the funds and fire-sale risk for the
2013 and 2014. Net outflows had not been seen since 2005,
markets in which they participate.”
according to Lipper, a fund researcher. In concert with this,
junk bond fund total net assets fell from $420 billion to
In September 2015, the SEC commissioners voted to issue
$378 billion between 2013 and 2014.
proposed new rules and amendments to older rules aimed at
enhancing the ability of mutual funds (excluding money
The Third Avenue Fund’s Problems
market funds) to better manage liquidity risks. Funds would
be required to adopt new plans for managing liquidity risks
Amidst the depressed junk bond environment, the Third
and would also be required to keep a threshold level of cash
Avenue fund saw the value of its assets fall from about $3.5
or cash equivalents that could be easily converted into cash
billion in July 2014 to $790 million by December 8, 2015.
within three days (currently it is seven days). In addition,
To date, among the 500 or so domestic junk bond funds, the
current agency guidelines that merely advise funds to cap
Third Avenue fund has been the only one to involuntarily
the percentage of their net assets in the form of illiquid
close its doors. Potential insight into the fund’s reportedly
assets that cannot be sold within seven days (such as Level
precarious financial state may be found in statistics that
3 assets) at 15% would be codified under the proposal.
illustrate the relative riskiness of the fund’s portfolio vis-a-
Critics, including fund industry representatives, claimed
vis that of other junk bond funds. Funds must group their
that the proposals would be unwieldy to comply with;
holdings into three categories based on the ease by which
would add significant fund compliance obligations; and
they can be valued. Holdings that are grouped into Level 3,
could impede the ability of junk bond funds to conduct
the hardest to value group, also tend to be very illiquid (i.e.,
legitimate investment strategies.
difficult to sell) with rather speculative valuations due to
the absence of similar assets in active markets with actual
Gary Shorter, Specialist in Financial Economics
valuations.
IF10360
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The Collapse of the Third Avenue Junk Bond Fund
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