High Yield’s Liquidity Conundrum

Renewed investor concerns over high yield bond portfolios led Fitch Ratings to take a deep dive into their construction.

Liquidity in the biggest individual high-yield fixed income funds varies significantly from one portfolio to the next, according to an analysis by Fitch Ratings.

“The transparency of mutual funds’ liquidity is limited and subjective.”The rating agency found that the 10 biggest US junk bond funds averaged 19% CCC or lower rated securities, including non-rated bonds. However, among the portfolios the allocations ranged from 6% to 53%.

Similarly, the funds’ level three assets—typically investments with estimated values rather than a liquid market valuation, such as some asset-backed securities—ranged from 0% to 17% of the portfolios.

Fitch’s analysis followed reports that the US Securities and Exchange Commission (SEC) had launched an investigation into high-yield liquidity.

“Liquidity in fixed-income markets has declined at the same time that fixed-income issuance and fund holdings have expanded,” Fitch said. “The SEC’s proposal includes classification of the liquidity of a fund’s assets, procedures for the management of a fund’s liquidity risk, and establishment of a three-day liquid asset minimum.”

The SEC is said to have begun probing the sector following Third Avenue Management’s troubled liquidation of a high yield bond fund last month. This would be on top of a broader review of liquidity provisions in mutual funds and exchange-traded funds, announced by the US regulator in September.

Third Avenue suspended redemptions from its Focused Credit Fund due to a wave of attempted withdrawals and is in the process of winding down the portfolio, according to the asset manager.

“The transparency of mutual funds’ liquidity is limited and subjective,” Fitch Ratings said. “Managers are not required to disclose estimates of the percentage of illiquid securities, and the optimal determinants of liquidity remain subject to study and debate.”

However, the ratings agency emphasized that Third Avenue’s Focused Credit Fund was “an outlier” in terms of its allocation to illiquid assets. At the end of November, the fund had 48% invested in bonds rated CCC or lower, and 41% in unrated securities.

“Lower rated bonds generally fall in value farther and faster than higher rated securities during times of stress,” Fitch said. It cited a 25% fall in the value of CCC bonds between June and December as a contributing factor to the fund’s problems.

Despite concerns raised by the SEC, some bond fund managers are eyeing attractive valuations in the high-yield sector following last year’s declines.

Mark Holman, CEO of fixed-income specialist TwentyFour Asset Management, cited quantitative research from Goldman Sachs into high yield: “Their view—and ours—is that oil prices need to hit a bottom, which they inevitably will quite soon, which will lead to an improvement in macro conditions that will tighten spreads gradually in H1 2016 and more meaningfully in H2 2016.”

Related: Another Distressed Debt Fund Goes UnderTowers Watson: Illiquid Credit Presents ‘Compelling’ OpportunityTransparency Rules Could Hinder Fund Capacity, Moody’s Warns