The Credit Market Collapse Intensifies – Redemption Gates Up Next

By Investment Research Dynamics

In the summer of 2014, I warned that liquidity was beginning to leave the credit markets and that mutual funds and hedge funds eventually would be instructed by the Fed to implement redemption “gates.”  We are getting closer to this reality.  As the credit market collapse advances, what has happened to the fund described below will spread to the majority of non-Treasury based fixed income funds.

If you own any bond mutual funds of any “flavor,” I am strongly suggesting that you stop reading this and pick up the phone and call your investment advisor or brokerage firm or mutual fund custodian and sell all of your bond fund holdings.  You will eventually regret ignoring this advice.

These “gates” are a mechanism to prevent you from taking your money out of a mutual fund at the fund’s discretion.  They are used when the value of redemption requests is higher than the fund’s ability to sell its holdings in order to meet the requests.  It generally means that a fund is marked too high on its assets and the market for the fund’s holdings is highly illiquid (i.e. no one wants to buy the bonds held by the fund).

The junk bond market is collapsing and it’s not just the triple-C tranche of assets.  it’s everything.  The problem is manifesting openly in the triple-C segment but it’s the tip of the iceberg.

As Zerohedge first reported, Third Avenue Fund’s “Focused Credit” junk bond fund has blown up.   This is the direct way of saying that it has announced that it is liquidating. It has suspended the ability of fundholders to request a redemption.   While it attempts to sell its garbage, it has announced that it will make a cash distribution to fund holders with what little cash it has on hand.  It will place the remaining fund holdings in a “liquidating trust” which will try to sell off the bonds that it can’t sell now.

A colleague of mine showed me some proprietary information that his firm had compiled on this Third Avenue Fund. Before I describe what was in the fund, let me just say that I am confident that none of the investment advisors, financial planners or securities brokers who put their clients into this fund had any clue how risky this fund was.

Up until early 2015, this fund had up to a negative 50% cash weighting.  This means that it had 50% “effective leverage” – it was more than 100% in the junkiest of the junk bond market.  Of that leverage, 97% was invested in C-rated bonds.  In other words, this bond fund was the equivalent of Fukushima nuclear waste.   As of July 2015, the fund had managed to raise about 10% cash and remove the leverage.    I assume that is around amount that will distributed.  Investors will thus receive about 10% of the quoted NAV in cash.

That’s not to say investors will get 10% of their original investment.  Depending on where the fund was valued when they invested, they will be getting back substantially less than 10% of their original investment.  There will be little to no hope of getting much beyond that, as most of the bonds in the fund are utter toxic sewage:  LINK.

Before you bristle at the thought of taking a loss on your current bond fund holdings and sweat over the thought of not earning any interest on that capital, you better contemplate the possibility of not being able to get most if not all of that money back at all at some point. Think about the people who watched in horror as their beloved Kinder Morgan stock dropped $44 in April to $16 now.  The whole way down they refused to sell because “it was too cheap.”  Really?

Those who wait are going to suffer through the eventual reality of having their money trapped in the bond market.  I’m not making this up.  There have been multiple warnings issued over the last year by several sources, including this website, that the credit markets were becoming very illiquid.  The Third Avenue Fund above is evidence of this and it’s not an “outlier.”   Most fixed income funds have hidden leverage and derivatives. Get out now while you can.

Courtesy of Investment Research Dynamics