Trouble in Junk Bonds

Last September, I wrote that we avoid junk bonds because they are too sensitive to stocks, which means that a portfolio of stocks and junk bonds isn’t as diversified as a portfolio that has stocks and investment grade bonds (click here to see the original article).

Over the last year, the S&P 500 has earned just 1.68 percent and suffered a 10 percent correction in the autumn.  Junk bonds, as measured by the Barclays High Yield bond index, have fallen -4.06 percent.  (All data is through Dec. 10, 2015)

While that’s not a terrible loss, there is a lot of hand-wringing on Wall Street about the junk bond market as investors wonder whether weak junk bond prices are an early warning signal for lower stock prices in the future or just more fallout from the lack of liquidity in the bond market (a subject that I covered this summer, click here).

The hand-wringing was kicked up a notch when the venerable Wall Street firm Third Avenue announced last night that they were going to stop allowing investors from pulling money out of their junk bond mutual fund while they liquidate the fund.

The fund was launched in 2009 because Third Avenue, which was founded by the well-known vulture manager Marty Whitman, saw a lot of opportunity in junk bonds coming out of the 2008 financial crisis.

While the fund posted impressive returns initially, the performance was negative last year and then got nailed this year, down -28.96 percent through yesterday.

As a result of the poor performance (of the fund and the sector), investors started pulling money out of the fund in droves.  The fund had $2.5 billion in assets recently but was down to $788 million last month due to the poor performance and investor withdrawals.

While blocking investor’s access to their own money is disturbing, it was done with their best interests in mind.  If they kept the fund open, they would be forced into selling their remaining positions at fire sale prices.  Presumably, they can get better pricing if they don’t have to worry about providing liquidity to their clients.

Even if it was the right thing to do, we think this is a terrible outcome for investors that could have been averted by avoiding this asset class in the first place.

This fund was also very concentrated (as the name implied), which is part of the reason why the fund has done so much more poorly than the junk bond index.  Again, this is the kind of thing we avoid for exactly this reason.

When the fund returns were hot – double digits while we were low single digits, clients expressed interest in this fund.  While they were satisfied with our explanation, it’s somewhat gratifying to see that our approach avoided this particular landmine (we’re not perfect, but it’s nice to miss a big bomb like this).

I’m not jumping to conclusions about whether this funds’ problem is a harbinger of things to come, but like the rest of the market, this news puts me a little bit on edge.