Using the right fund structure can help investors avoid liquidity mismatches. The increasing popularity of high yield bond funds brings this issue to the forefront. A recent Barron’s article: Bond Investors are Better Off in ‘Interval Funds.’ Here’s Why. compares interval funds and mutual funds that invest in high yield bonds.
Bond fund liquidity mismatch
The increasing popularity of high yield bond funds brings the issue of liquidity mismatches to the forefront. There are plenty of opportunities in credit, but investors need to find the right vehicle for the right strategy. When the average high yield bond only trades nine times per week, a daily liquidity structure such as a mutual fund probably isn’t appropriate. Yet completely illiquid private funds don’t work for all investors. Interval funds, which require the manager to conduct regular tender offers for at least 5% of shares, are an ideal compromise. A recent Barron’s article compares interval funds and mutual funds that invest in high yield bonds, discussing how fund structure can lead to a liquidity mismatch. When it comes to high yield bonds, interval funds are better suited for today’s investing environment.
Liquidity mismatch in bond funds
In the world of bond funds, one major underappreciated risk is the liquidity imbalance that exists between funds and theirs shareholdersSource: Bond Investors are Better Off in ‘Interval Funds.’ Here’s Why
Third Avenue Focused Credit Fund was a mutual fund that invested in illiquid distressed debt. When its performance faltered, investors rushed for the exits, forcing a fire sale of assets. Ultimately it was unable to meet redemptions. Subsequently, received SEC exemptive relief to gate redemptions in 2015. Mackenzie Capital, did a mini-tender offer at $2.00 per share(~30% of NAV) in 2016. The Third Avenue Focused Credit fund is a prime case study in the importance of aligning fund structure with strategy.
As I noted for the Barron’s Article:
If Third Avenue [Focused Credit] had been an interval fund rather than a mutual fund, it would not have been as big a problem…It would have taken investors a while to exit, and [it] wouldn’t have needed to completely gate the fund.
Another case study is the Chou Income and Chou Opportunity funds. After it sold down its most liquid assets to meet a wave of redemptions, a large portion of portfolio ended up being highly concentrated in debt of Exco, which was in bankruptcy at the time It paid investor redemptions in cash while it could, and the final liquidation plan was a mix of post reorg Exco stock and cash. As with Third Avenue, it was unable to meet the daily liquidity requirements of mutual funds. If it been an interval fund with quarterly liquidity of 5%, it would have been able to meet its liquidity obligations and rebalance the portfolio. Its easier for a manager to avoid a liquidity mismatch when they use an interval fund structure.
Better equipped for today’s environment
Over half of the interval funds currently pending registration are focused on credit strategies. Why have so many credit managers launched interval funds? The answer is the current credit environment:
Interval funds are structurally better equipped for today’s environment, when a record number of high-quality bonds have been downgraded to junk credit ratings. An excess supply of high-yield debt with falling demand can engender forced selling.
The full article goes on to discuss several examples of high yield bond interval funds.
Avoiding a liquidity mismatch can help investors get maximum benefits from the bond funds.