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By Russel Kinnel and Christine Benz | 12-16-2015 11:00 AM

What the Third Avenue Fund Failure Can Teach Investors

Investors should be aware of the general risks of buying bond funds that own non-rated, smaller issues, and the specific risks that the energy sector brings to high-yield funds today.

Christine Benz: I'm Christine Benz for Morningstar.com. Third Avenue rattled some investors in early December when it announced that it would be liquidating its Focused Credit Fund. Joining me to discuss some of the takeaways for all investors is Russ Kinnel, director of fund research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, let's talk about what was in that Third Avenue portfolio. Are the sort of illiquid assets that populated that portfolio perhaps a mismatch with a fund that gives investors daily access to their cash?

Kinnel: It was a fund that invested, as the name implies, in a fairly concentrated portfolio of distressed debt. "Distressed" is generally a level lower than most junk bonds go into. These are names that are having trouble or people are worried will have trouble making their payments, and in this case that meant a lot of energy. As you know, oil prices have plummeted. So, they have gotten even worse.

What happened was the fund had redemptions that forced it to sell, and eventually it had to try and sell some of that distressed debt. But no one wanted to buy it, so they realized they had to liquidate the fund, but they could only do that very slowly--they said over a period of a year, or maybe even more. That way they will be able to get a decent price for the bonds.

As you say, the central issue here is that some securities are not that liquid, and therefore are maybe not a good fit for a mutual fund, because mutual funds have to offer daily liquidity. And typically mutual funds go to great lengths to manage that liquidity. They think about different tiers of meeting redemptions. Obviously they will have cash or have other things. There is a reason that not many funds have gone where this fund went.

Benz: Is it your view that if a fund is going to own illiquid securities that maybe it should be a closed-end fund or an interval fund that only gives investors their cash back at preset periods of time?

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