Risk! Where? Part I.

The Third Avenue Focused Credit Fund, aka a junk bond mutual fund, moved swiftly to prevent redemptions by transferring the fund’s assets into a liquidating trust today. With the assets locked up, and no cash flows in or out unless at the behest of the fund manager, the manager hopes the underlying junk bonds can be sold in a rational way, rather than at fire sale prices forced by shareholders wanting their money. The fund owns some of the shakier issues available in the market, on the theory that many of these could heal themselves and prove to be more valuable later.

But the market has moved against the fund as the situation in the oil patch begins to spread beyond energy alone.

Unfortunately, the formation of the liquidating trust means shareholders can’t get their money until Third Avenue decides to make sales. So this is what can happen to a mutual fund in a distressed situation. In an extreme situation, if an investor’s whole portfolio was invested in, say, three funds that behaved this way, his money turns out to be locked up.

We are not fans of mutual funds, and this situation just provides more ammunition against these overblown products.

Aside from recognizing this event as an investment risk, it shows how fragile some areas of the economy are. Liquidity has dried up in some assets. Who needs the Fed when you have the markets to make interest rates for shaky credits leap well into double digits? And now, with the Fed actually on the brink of a rate hike, we’ll see who else is naked as the tide goes out.