High-leverage and high-yield funds may have to change strategy or shut down as a U.S. interest rate increase appears imminent. Third Avenue Focused Credit Fund has suspended redemptions and says it will liquidate. The fund has almost $1 billion in assets, down from $2.75 billion last year. Liquidation of a high-yield bond fund typically takes about a year. A Stone Lion high-yield fund that is half as large also suspended redemptions today. It isn’t immediately clear whether the Stone Lion fund will have to liquidate, but that is a common fate of a fund that cannot meet its cash requirements. The fund represents a third of Stone Lion’s total assets.
Redemptions leading to a loss of solvency is a recurring problem with bond funds, which as a rule keep very little liquidity and can go from normal operations to insolvency in just two or three trading sessions when investor sentiment turns. This is a risk that is not widely recognized because it a risk of bond funds themselves, not of the underlying bonds. Given the risk, conservative individual investors should never invest in bond funds, and as investors decide to get out before it’s too late, more bond fund redemptions and liquidations are almost surely on the way.
U.S. interest rates have not increased in nearly a decade, and there are questions about how well the financial sector is positioned to survive normal interest rates when they return around 2019. Interest rate increases put more pressure on distressed business of all kinds, and lenders will inevitably take losses on some of their loans to marginal businesses.