Let’s break down what is happening today in less than two minutes.
What Are Junk Bonds
Companies who need to borrow money can issue debt. It’s just a loan. You can buy the debt and the company will pay you a high interest rate or a low interest rate (for loaning them money), depending on how risky their business is.
When a company issues “high yield” debt (because the revenues or earnings or growth of their company may or may not be very reliable right now), another name for this debt is “junk bonds.” High yield debt is just a nicer word than junk. Kind of like our break up was mutual vs. we broke up because he’s an asshat.
How Is This Tied To Oil?
The U.S. high yield debt market is dominated by energy companies.
Oil prices are down about 50% over the last year.
Energy companies sell oil.
If prices have fallen, their revenues are lower.
Here’s the one-year chart of oil:
What Are Junk Bond Funds
These are funds that take your money and invest them in a bunch of high yield debt (bonds). The fund collects high interest payments from each of the bonds (which gets passed to the investor, you). The fund also hopes that the value of the bond will increase over time (so they can sell the bond for a profit), i.e. it would be less junky then, which means the interest rate would have decreased.
What Does This *Hedge Fund Have To Do With This?
Third Avenue Management offered a hedge fund to investors that did just that. It took investor money and invested it in high yield debt for them.
The fund went from over $2 billion in assets in May to about $780 million right now. That’s a lot of assets to lose in a short timeframe so last week they told investors they can’t take any more money out of the fund. Assets are flying out the door too fast, this needs to be orderly!
This is often called a gate. If a fund loses a specific amount of assets, the gate allows them then halt all redemptions and divy out what’s leftover a specified time frame. The intention is to protect investors who are still in the fund.
When the fund’s performance deteriorated this year and investor redemptions surged, it started liquidating some of its investments, but its outsized holdings enabled savvy traders to quickly figure out that a large investor was under pressure to sell, this person said
In other words, the amount Third Avenue was trying to unload in the market was so big (to meet investor redemptions) that buyers started sensing their desperation. What would you do if someone was desperate to sell you something? You’d lowball the price.
By gating the fund (or not allowing any more investors to take their money out johhny on the spot (they have to wait their turn), this helps Third Avenue from having to sell (to raise cash) into the death spiral of junk debt’s falling prices.
Re: Third Avenue. Their “Focused Credit Investor Fund” looks like a garbage fund all around. Yes, they invest in risky debt (high yield/junk bonds), but with fund performance -28% for the year when the high yield index is down closer to 3.8%, it is just unforgivable (apparently their investors felt the same way).
Third Avenue is suggesting that they’re gating their portfolio because they need to protect existing investors. I’m sure that’s true. But the fund is losing (lost) its rear because the portfolio mangers made a bad bad call and put too much investor money in junk debt of oil companies and other highly risky sectors. In May, from Barron’s:
Lapointe (the portfolio manager) is particularly focused on distressed oil names now that prices have fallen and investors are abandoning oil-company bonds, which make up 15% of the high-yield market. “There’s nothing better than people running out of a building with their hair on fire,” he says.
Unless it’s your hair.
Yes, with a gate you’re protecting your existing investors because you don’t have to fire sale all your assets to meet redemptions. And yes, liquidity may be poor. But you really just fudged up on your oil-company high yield bond call.
What About Meeeeeee?
If you’re invested in an bond fund that invests in high yield debt, like one of Vanguard’s High Yield bond funds, the fund is down slightly for the year (this is through Nov 30th).
Contrast this with the Third Avenue Focused Credit Investor fund:
Take a deep breath and get back to work.
*One of our astute readers pointed out that the fund that Third Avenue was offering is not a hedge fund. It is traditional mutual fund. Glad to know you’re all awake and reading this. Thank you Anthony.