Devising a High-Yield Bond Fund Exit Strategy

After long piling into funds that bought some of the lowest-rated debt, investors are asking themselves a basic question now: When they decide to get out, will they be able to?

That fundamental attribute of mutual funds got new scrutiny this week, as Third Avenue Focused Credit Fund took the unusual step of blocking redemptions and telling investors it could take a year or more for them to be paid all of what they are due. The fund said it put up the gates to facilitate an orderly liquidation amid severe declines in bond prices and heavy withdrawal requests.

Third Avenue may be unique given its outsize weighting in particularly risky and hard-to-sell securities, said Jeff Tjornehoj, head of Americas research at Thomson Reuters Lipper. Still, he and others said other funds also could be at risk of a liquidity squeeze—and pointed to measures that investors can look at to gauge a fund's chances of having to scramble to pay departing investors.

Those factors include a fund's exposure to assets that may prove particularly hard to unload, its cash cushion, the degree of concentration in top holdings and the magnitude of recent outflows.

In looking at junk-bond funds, one thing to consider is how a fund allocates its assets among bonds of different credit ratings and/or debt that isn't rated. The Third Avenue fund had 89% of its assets in debt that was rated lower than B or not rated, according to Morningstar data.

"Nonrated, it can be harder to trade under stress," said Russel Kinnel, director of manager research at Morningstar Inc.

Some senior executives in the industry say problems at the Third Avenue fund are representative of risks taken by managers of one portfolio, rather than signs of a systemic problem in mutual funds. They argue that mutual fund managers have a long track record of handling heavy redemptions and winding down funds where necessary.

Current Securities and Exchange Commission guidelines say mutual funds should hold a maximum of 15% of their total holdings in illiquid assets. The regulator in September proposed a new rule that would overhaul how funds manage liquidity risk, or the potential that their investors won't be able to cash out promptly at the prices they have been led to believe their fund holdings are worth.

Another risk indicator: how much of a mutual fund's assets are concentrated in its top 10 holdings, Mr. Kinnel said. The typical fund will have a diffuse portfolio. Vanguard High-Yield Corporate Fund, for example, had 9.1% of its assets in its top 10 holdings, and its top holding accounted for about 1.4% of the portfolio as of Sept. 30, according to Morningstar. Third Avenue Focused Credit Fund, in contrast, had 28.4% of its assets in its top 10 holdings, and its top holding accounted for nearly 4.8% of the fund as of the end of July, according to Morningstar.

High-yield funds attracted net inflows for nine months in a row to May 2014, as investors searched for returns amid a prolonged period of low interest rates. But flows have been more volatile since. Investors pulled money from high-yield funds in six months of the 11 months this year, according to Morningstar, including a $3.3 billion outflow last month.

Concerns are heightened now because investors often move to sell money-losing fund positions and investments late in the year to generate losses that can offset their taxable income. The average junk bond fund is down 3% so far this year, after counting dividend income, according to Morningstar, but some are down more, making those holdings a logical choice for some investors to sell.

Concerns about liquidity in parts of the bond market could make exits more likely.

"When a fund offers liquidity on a daily basis but holds illiquid assets, it creates a first-mover advantage," said Itay Goldstein, a finance professor at the University of Pennsylvania's Wharton School.

An investor who redeems shares of the fund will receive net asset value as of that day's market close. But that price doesn't reflect what the fund can collect for the assets it has to sell.

"Those costs of liquidation will be imposed on the other investors who stay in the fund," he said. "If you're the first one to leave, you're in better shape than those who wait."

Among the 10 high-yield funds that have seen the biggest outflows in dollars this year, a spokeswoman for Aberdeen Asset Management PLC said the company's global high-income fund is well diversified and invests in more-liquid segments of the high-yield market. A Fidelity Investments spokeswoman said the firm is confident in the positioning and liquidity of its high-yield funds and continues to view the asset class as an attractive one for long-term investors.

A Franklin Resources Inc. spokeswoman said the firm hasn't had any issues managing redemptions and maintains a line of credit that its high-yield funds have never used. "We have experience managing through all market cycles, and we look ahead to prepare for periods of higher outflows by holding a cushion of liquid investments," she said.

Avenue Capital Group, Metropolitan West Asset Management LLC, Waddell & Reed Financial Inc., Pacific Investment Management Co. and American Funds either declined to comment or didn't respond to requests for comment.

Write to Daisy Maxey at daisy.maxey@wsj.com, Sarah Krouse at sarah.krouse@wsj.com and Jason Zweig at intelligentinvestor@wsj.com

(END) Dow Jones Newswires

December 13, 2015 19:35 ET (00:35 GMT)

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