My colleague Ben shared an interesting take on this past week’s events in the junk bond market that I wanted to pass along. K.C. Nelson, a portfolio manager at Driehaus Capital Management, explains some important aspects of the Third Avenue bond fund situation that haven’t quite made it into the press as yet.
Long story short, Nelson shows how Third Avenue’s fund – which has suspended redemption requests giving it time to liquidate hard-to-sell credits – is actually more like a junk bond portfolio on steroids than it is a typical offering in the space. Nelson calculates that the majority of the fund’s holdings are triple-C – the worst of the worst – and the average yield across its bond holdings is an astounding 38%! Additionally, it is heavily concentrated and has many holdings in which it owns more than 20% of the outstanding paper, making sales that much harder.
One interesting portion is where he relays the following questions investors should ask to determine whether or not they’re in an at-risk fund:
What questions would you ask if you were worried about liquidity in a credit portfolio?
What’s the yield of the fund? If it’s greater than 1.5x to 2x the index, then there are likely some juicy (aka, perhaps distressed and illiquid) holdings in the fund.
What’s the average dollar price of the positions in the fund? If it’s below 70, that should tell you something.
How many holdings do you own where you comprise more than 10% of the outstanding issue? There were a number of positions in this list where the fund held about 20% of the issue, and that can make liquidity quite difficult should you need to sell.
How many holdings do you have that aren’t current on their coupon or are in a form of restructuring? Generally, though not always, liquidity is materially poorer for these types of companies.
Most of these questions can be answered within a few clicks on a Bloomberg terminal. If you’re not in a position to ask them (or understand the implications of the answers), you’re in the wrong fund or should be seeking the help of a professional investment advisor.
I know that there are many wealth management clients in this country who’ve had funds like these (maybe not quite as severe as this one) added to their asset allocation in order to juice the portfolio’s overall current yield. It’s been a sales strategy to show rich people a higher “sticker price” yield versus a competitor to win the account – “Your Merrill guy’s portfolio is only giving you a 3.75% yield, but you deserve better. We can get you 4.50%, Mr. Jones…” We see dozens of portfolios every month, and we’ve seen it all.
It’s not too late to figure out the true nature of the risks you’ve been taking should the credit cycle be turning down.