This blog post continues our series on the ongoing crisis in high yield and distressed debt bond funds. For our previous coverage, see: "What's Going on in High Yield and Distressed Debt?" and "The Third Avenue Focused Fund Implosion".
Formerly liquid market: Aral Sea, Kazakhstan.
The suspension of redemptions in the Focused Credit Fund (an open-end mutual fund) is remarkable. Although all mutual funds have the right to suspend redemptions, until now, it has been an extremely uncommon occurrence. This may change in the new market reality of reduced bond (and bond fund) liquidity.
The Focused Credit Funds suspension will last until investors are given interests in a liquidating trust that will hold the Fund's assets and sell them over time. (It is unlikely that a liquid market will develop for interests in the liquidating trust.) This is similar to a Chapter 7 bankruptcy, where a trustee is appointed to liquidate a debtor's assets and use the proceeds to pay the claims of the firm’s creditors.
The travails of the Focused Credit Fund arise out of a liquidity mismatch: the Fund owns highly illiquid investments in a vehicle that provides investors with daily liquidity.
This is something like a liquidity Ponzi: as long as asset prices are rising and money is still coming into the Fund, it will work. If nothing else, redeeming investors can be paid out from new investors. However, as soon as prices start to fall and new money stops coming in, the gig is up.
This is very similar to what happened in the Auction Rate Securities ("ARS") market. As long as there continued to be clients putting money into ARS, they functioned as a liquidity provider for other clients who wanted to sell. However, as soon as the new money stopped coming in, the broker-dealers that were the liquidity of last resort quickly got their fill of ARS and backed away from the market.
Two significant events have led to less liquidity in fixed income markets since the financial crisis:
- Federal Reserve open market purchases of trillions of dollars of US Treasury bonds and mortgage backed securities;
- Wall Street firms have dramatically reduced their inventories, by some counts up to 75 percent.
Chart 1: Primary Dealer Positions
The Illusion of Liquidity
Liquidity is, and always has been, mostly an illusion. Ask yourself a simple question: can all the owners of any security, currency, or contract have liquidity at the same time? The answer is obviously "no".
So who gets liquidity?
Certainly sellers who are selling into a rising market get liquidity. Also, sellers when the market is flat. However, the story changes when the market is in decline. The first sellers can get out (albeit at lower prices) but when a lot of sellers hit the market at the same time, buyers can just disappear. In this case the only buyers left are vultures, buyers of last resort who are willing to take securities from forced sellers, at cents on the dollar.
This is the situation the managers of the Focused Credit Fund find themselves in, and is why they have suspended distributions and put the assets in a liquidating trust.
The problem for them is that everyone now knows they are sellers only, and to make matters worse, everyone knows what they own. They are unlikely to see any improvement in the marks on the bonds and loans they have.
Simply put, all distressed and high yield bond funds are now sellers as their client’s submit redemptions. Even clients who would prefer to stay in a fund are motivated to redeem their shares as they get hurt by their panicked co-owners.
In my next post, I will examine the suitability of complex, illiquid, and high risk investments.
 U.S. Courts; “Bankruptcy Basics”. Available at http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics. Accessed December 14, 2015.
 SEC Commissioner Daniel M. Gallagher. Speech delivered on March 10, 2015; “A Watched Pot Never Boils: the Need for SEC Supervision of Fixed Income Liquidity, Market Structure, and Pension Accounting”. Available at: http://www.sec.gov/news/speech/031015-spch-cdmg.html#_edn11; Accessed December 17, 2015.
 BBVA Research; “Heightened Bond Liquidity Risk is the New Normal”; September 3, 2015. Available at: https://www.bbvaresearch.com/wp-content/uploads/2015/09/150903_US_EW_NewLiquidityDynamics.pdf; Accessed December 17, 2015.
For information about high yield and distressed debt expert Jack Duval, click here.