ETFs Solve Mutual Bond Fund Problem

Third Avenue failure shows why bond mutual funds are terrible and bond ETFs are king.

The stunning failure of the Third Avenue Focused Credit Fund this week is proof positive that exchange-traded funds are a better (and, indeed, the only fair) structure for delivering exposure to the corporate bond market.

As reported by various media outlets, the New York-based Third Avenue Management had to block investors today from withdrawing money from its Focused Credit fund, as massive redemptions overwhelmed its ability to sell bonds and pay shareholders in cash.

The fund had previously lost nearly two-third of its assets since the end of July, with assets under management falling from $2.1 billion to just $789 million. As assets fled, the fund likely sold all of its relatively liquid securities to meet redemptions, leaving it with a bag full of illiquid junk. With more investors asking for their money, it couldn’t sell things fast enough to meet redemptions and keep the other investors in the fund whole.

Here’s what CNBC said:

“Heavy redemption demands from investors and reduction of liquidity in the bond market made it difficult for the fund to continue without selling assets at fire sale prices, putting remaining shareholders at a disadvantage, Third Avenue Management said in a letter to investors.”

Risk Is Playing Out

I’ve warned about the risks of bond mutual funds many times in the past, and this is exactly what I was talking about.

The problem with bond mutual funds is that investors can redeem their shares at the stated net asset value of the fund at the end of every day. If you hold a bond mutual fund and the fund has a stated net asset value of $20/share, you can demand $20 in cash from the fund.

In normal times, that works out fine. You redeem your shares; the fund sells some bonds; the fund pays you in cash. But in distressed markets, everything goes awry, because the NAVs that bond funds use to process those redemptions are pure fiction.

What’s Wrong With Bond NAVs

The way you calculate NAV of a fund is to look at the closing price of each security the fund holds, and look at how many shares of that security the fund holds, and calculate up from that. That works great in equities, where there is one agreed-upon closing price for every security. We all know the closing price of Apple stock yesterday.

But there is no centralized market in the bond space, and no agreed-upon closing price. Many bonds do not trade for days or weeks at a time. As a result, funds use “bond pricing services” to guess at the value of each bond and hypothecate an NAV. These pricing services look at reported trades for those bonds that did trade, and prevailing market conditions, and make their best guess at the value of the portfolio.

During times of stress, as we explained here, these services tend to significantly underestimate the amount that bond prices really fall (and overestimate the true clearing price of those bonds). That creates a real problem. If you have to sell $22 of “stated value” to generate $20 in cash, you can’t possibly process all the redemptions needed to pay your investors in cash. In the case of Third Avenue, it sold all the bonds it could realistically sell at their stated value, and was left with a pile of junk that wouldn’t clear at reasonable prices.

The ETF Solution

ETFs solve this problem. When there is significant selling in a bond ETF, the bond’s price will fall below the stated NAV. This is called “trading to a discount.” The reason bond ETFs trade to a discount is that the stated NAV is artificially high (as the Third Avenue example makes clear).

But unlike mutual funds, the only people who can redeem shares of an ETF at NAV are a group of institutional investors called authorized participants (APs). And critically, when these APs redeem shares, they don’t get paid in cash … they get paid “in kind.”

In other words, if they redeem 100,000 shares of a bond ETF with an NAV of $20/share, they don’t get $2 million in cash; they get $2 million in bonds from the fund’s portfolio. It’s their responsibility to sell these bonds in the open market and turn them into cash.

This makes all the difference in the world. Because they get paid “in-kind,” and because the bonds they receive are valued by the same service that creates the NAV, there is never a gap. A $20 redemption gets you $20 in bonds. You could theoretically redeem all the shares of an ETF and get the ETF’s entire portfolio of bonds, and it would work perfectly.

The Downside

The only downside of this problem is that, because the APs bear the risk of liquidating the bonds, sometimes they will allow bond ETFs to trade to a substantial discount to their NAV before they step in and arbitrage the difference.

If the bond ETF’s stated NAV is $20/share, but the APs only think they can get $18/share for the bonds they’ll receive in kind, they won’t step in until the ETF trades to $18/share.

People have gotten all up-in-arms about this, worried that the discounts in ETFs expose some sort of problem with bond ETFs. In reality, all those discounts say is that the stated NAV is baloney, and the real clearing price for the bonds is lower.

The beauty of the ETF is that, because all the redemptions are in-kind, shareholders who don’t sell are protected from any harm by those that do. And eventually, when markets normalize, the ETF trades back to its stated NAV and everyone goes on their merry way.

Third Avenue did the right thing by freezing its fund. Allowing continued redemptions would have hurt any shareholders who didn’t sell. But the fact that they had to do that points out everything that’s wrong with bond mutual funds, and why the ETF is by far the superior structure.