The Mutual Fund Equivalent of Bankruptcy

The recent decision by the managers of a fund invested mainly in high-yield, or junk, bonds to put their fund into the mutual fund equivalent of bankruptcy reminds us that mutual funds are like banks in an important way. Namely, both banks and mutual funds invest in long-term assets, yet promise short-term liquidity.

That basic mismatch makes runs on mutual funds a real possibility, particularly if the fund’s assets are not particularly liquid.

Last week, Third Avenue Management said it was halting redemptions from its Focused Credit Fund and would instead liquidate the fund through a trust mechanism. That is, the fund has closed its doors and will pay out when it can. No more daily liquidity for investors. It is as if the fund is in bankruptcy, without the transparency associated with the normal bankruptcy process.

The lesson for investors in other junk bond funds is to get out before redemptions are stopped by such a block at their fund. If everyone tries to beat their neighbor out of these types of funds, it will look very much like an old-school bank run.

Which is why it might not have been such a crazy idea to think about whether certain mutual funds might be systemically important.

It appears that the regulators have backed off consideration of this issue — which seems to have been more focused on the managers than the funds, in any event. But it will only take a couple of more funds going into this rough equivalent of bankruptcy for investor panic to become fairly palpable.

Regulators are focused on the failure of a handful of really big financial institutions, because that’s the crisis that we just experienced. But what about the failure of an entire class of financial institutions, like mutual funds? Each fund is much smaller than Lehman Brothers or the American International Group, but grouped together, could they have similar effects?

The key question is probably whether this spreads beyond junk bond funds. Regulators can avoid some of the political pressure here by making a kind of “assumption of the risk” argument: Investors who buy funds that invest in high-risk, low-quality debtor firms are simply incurring a risk they were paid to take, even if it is coming in a form slightly different than expected.

But if the broader universe of bond funds were to come under pressure, regulators would have to be worried about the effects on the economy. After all, the country is particularly reliant on bond markets to fund corporate America.

Article from:- http://www.nytimes.com

 

 

 

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