The recent announcement that the Third Avenue Focused Credit Fund (“FCF”) has blocked investor redemptions brings flashbacks to 2007. The suspension of redemptions from three BNP Paribas funds, following similar actions by Bear Stearns and Union Investment Management, passed relatively unnoticed outside of financial markets at the time. However, the suspensions flagged growing stresses in financial markets after a period of increased risk taking.
The FCF invests primarily in High Yield (“HY”) bonds, a category of securities that has become increasingly popular in recent years as investors have sought returns in today’s (near) zero interest rate policy world. My understanding is that the FCF experienced substantial redemptions lately and that many of its remaining holdings are in bonds issued by companies in financial distress and/or re-organisation. While the primary cause of the FCF’s current predicament might well be FCF-specific, the consequences of the suspension might have wider implications.
The 2007 suspensions came around the same time as equity markets peaked, and well after credit markets started to experience stress, whereas equity markets are already down over 10% from their peaks earlier this year. However, opportunity remains to apply the experience of the subsequent evaporation of market liquidity seen in the previous cycle to current markets. The benign conditions prior to the downturn were evident in both cycles. Why might the spread of negative sentiment from credit space to other markets be materially different this time?
The crisis of liquidity in the 2007-9 downturn resulted in sellers having to accept prices for assets well below the cash flows subsequently generated by those assets. However, many sellers were forced to liquidate positions due to the structures in which these positions were held. These same pressures impacted the FCF, which is an open-ended vehicle and consequently has to provide liquidity to redeeming investors when these investors demand their cash back – unless redemptions are suspended, as is now the case. The liquidity provided by open-ended funds becomes particularly challenging if these funds invest in less-liquid assets and the funds are subject to material net redemptions.
The HY market has historically been less liquid than the Investment Grade and Government bond markets. However, the current market cycle has seen the emergence of a proliferation of open-ended vehicles active in the HY market. These vehicles have created an illusion of the true liquidity of the underlying investments. Market participants are well aware of these vehicles, and often their underlying holdings too, and are able to position themselves to take advantage of forced sales driven by redemptions. Offers for bonds being sold to meet redemptions in these vehicles can be set at levels lower than would otherwise be the case, in the expectation that the sellers will have to accept these offers in order to meet the redemptions. This process negatively impacts the performance of these vehicles, often triggering further sales (unless redemptions are suspended), leading to a downward spiral of prices.
This self-perpetuating destruction of capital by sellers crystallising losses in the HY market might undermine sentiment in other markets, leading to a wider loss of confidence and related sell-off. The increase in popularity of multi-asset funds in recent years has increased the link between different markets too. Many of these multi-asset funds have HY exposure. This exposure is negatively impacting the performance of these funds, creating another trigger for sales across multiple markets when these funds are liquidated.
Yogi Berra made his name on the baseball diamond rather than in investment markets. However, many of his unique sound-bites resonate in the financial world. He was clear that “you can observe a lot by watching” and much like in previous cycles “we made too many wrong mistakes”. He felt that “the future ain’t what it used to be”, which seems to be the prevailing sentiment in financial markets.
I can see the potential for further sell-offs in financial markets, for both fundamental and technical reasons. However, this market weakness ultimately implies opportunity, much like the aftermath of 2007-9. Quality assets are becoming available at more attractive prices than in recent years. Buyers might experience some mark to market pain in the short-term but it is impossible to call the bottom of the market. Long-term investors are best positioned to reap the benefits of the weakness, as was the case arising from the 2007-9 downturn. How about preparing to capture the better value that is emerging?