Biggest Mutual Fund Failure Since 2008

(Reuters) – New York-based Third Avenue Management is blocking investors from withdrawing their money from a near $1 billion junk bond fund as it tries to liquidate the fund in the biggest failure in the U.S. mutual fund industry since the Primary Reserve Fund "broke the buck" during the 2008 financial crisis.

The demise of the fund is sure to renew fears that less liquidity in the corporate bond market will cause more volatility, especially as the Federal Reserve leans toward raising interest rates next week for the first time in a decade.

“People will read into this that there are some possible ramifications or concerns around liquidity and how people are positioned,” said Adrian Helfert, head of global fixed income at Amundi Smith Breeden, the North American investment arm of Paris-based Amundi, which has more than $1 trillion in assets under management.

Assets Fell In Half

Heavy redemptions and losses since the end of July cut the size of the Third Avenue Focused Credit Fund by more than half, with assets falling below $1 billion from $2.1 billion, according to Lipper Inc. The latest data from Morningstar Inc. showed the fund having just $789 million in assets as of Thursday.

Net investor withdrawals from the fund accelerated in November, totaling $319 million, according to Lipper. Third Avenue did not return messages seeking comment.

A large investor in the fund, as of Oct. 30, was Boston-based Fidelity Investments' Strategic Advisers Income Opportunities Fund, which had a $128 million stake.

Poor Performance Of Holdings

This summer, the Third Avenue fund had been "overwhelmed by the poor performance of its lower quality, distressed holdings," Fidelity portfolio manager Gregory Pappas said in an August interview posted on Fidelity's website.

Fidelity was not immediately available for comment on whether the fund still had exposure to the Third Avenue fund at the time of its announced liquidation.

Meanwhile, as Third Avenue prepares to begin liquidating the fund next week, the investment management company said it has blocked further redemptions.

Preventing Asset Fire Sale

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.

The fund had one of the highest exposures to illiquid assets in the junk fund sector, according to a Reuters analysis.

About a year ago, the Focused Credit Fund had $2.75 billion in assets, but 18% of that amount included exposure to securities deemed illiquid. These so-called Level 3 assets typically carry valuations pegged to assumptions made by the investment managers themselves.

Energy Exposure Hit Fund Hard

The most illiquid assets in the portfolio included common stocks and warrants in the energy sector, convertible preferred stocks and corporate term loans, according to fund disclosures.

The fund realized $20 million in losses on debt issued by companies in the chemicals sector, for example, and a $15.5 million loss on exposure to the food and beverage industry, according to the fund.

The fund's year-to-date total loss of 26.98% is nearly nine times worse than the 3.0% average loss in the junk bond sector, according to Lipper.

As the fund's assets dwindled, its exposure to the illiquid assets increased to 20% at the end of July.

Fund Targeted Comebacks

In an October 2014 interview with Reuters, Tom Lapointe, manager of the Focused Credit Fund, said he liked investing in troubled companies poised for a comeback.

The volatility of the fund was apparent in the third quarter of 2011, when bond markets were rattled by the Greek debt crisis. The Third Avenue fund dropped 12%, while peers lost an average of 7.0%.

Third Avenue anticipates that the full liquidation process may take up to a year or more before a final distribution is made in order to achieve favorable results, saying, "Third Avenue is extremely disappointed that we must take this action."