Junk-Bond Funds Settle Down After a Rough Week

High-yield funds rebounded Tuesday and Wednesday after suffering losses on the three previous trading days following the announcement last Thursday that Third Avenue Management had shuttered Third Avenue Focused Credit. While that fund is atypical in that it employed a high-risk strategy focused on distressed debt, its closure exacerbated already-heightened concerns in the high-yield sector after last week’s sharp drop in oil prices and the anticipation of the Fed’s rate decision. Losses in the high-yield bond Morningstar Category, however, have not been severe. The average fund in the category fell 2.3% from Dec. 10 through Dec. 14. That said, it has been a rough year for the junk market, with the most pain coming from energy and commodity-related sectors, which have been hit hard by the slowdown in China. The average loss for the category was 4.2% for the year to date through Dec. 16. Some of the hardest-hit funds, including

After experiencing $25 billion in estimated net outflows in the second half of 2014, flows to the high-yield sector have been volatile through 2015. The high-yield bond Morningstar Category had seen an estimated $5.1 billion in net outflows for the year to date through November 2015, a trend that continued into December. That said, conversations with market participants suggest that these flows have thus far been manageable.

What’s going on in the ETF market?

The high-yield exchange-traded fund market seems to be acting reasonably well over the month to date. According to BlackRock,

How likely is it that other high-yield funds will follow in Third Avenue Focused Credit’s footsteps?

Not likely. Most high-yield mutual funds have far less risky portfolios than Third Avenue Focused Credit. That fund’s willingness to invest heavily in distressed names made it one of the riskiest high-yield funds around. The portfolio stood out for its substantial allocation to the lowest credit-quality tiers of the junk-bond market, its sizable stake in not-rated credit, and its concentrated portfolio. As of July 2015, the fund allocated close to half of its portfolio to bonds rated below B and another 40% in not rated fare. By contrast, the median allocation to below-B rated debt in the high-yield Morningstar Category is just 12%, and most funds hold only small allocations to not-rated debt. (Firms often classify equity positions as not-rated, explaining the large not-rated stake reported by several funds including Silver-rated

What are signs of outsized credit or liquidity risk? There are several telltale signs to look out for, such as large stakes in lower-quality bonds, especially if such positions are concentrated in individual names or sectors. Not-rated bonds make up a tiny part of the market, while bonds rated CCC or below account for 13% of the Bank of America Merrill US High Yield Master II Index. Positions like these could be difficult to unwind in a stressed credit market and are more susceptible to permanent capital impairment. Another sign is yields that well exceed market norms, as they can denote outsized credit or liquidity risk. Through November, the median 12-month yield for the high-yield category was 5.6%. Finally, shareholder concentration or volatile flows can leave a fund vulnerable to a large redemption request at a highly inopportune time, raising the risk that the manager will have to sell quickly, driving down prices in the process.

If my high-yield fund doesn't have those telltale signs, is it safe? You can breathe easier, but keep in mind that junk-bond investing does carry risks. Because of their imbedded credit risk, high-yield bonds are riskier than high-quality bonds like Treasuries and investment-grade corporate bonds. While they're not as risky as equities, junk bonds can behave more like stocks than like bonds, especially in risk-off environments. Over the past five years, the high-yield bond market has shown a correlation of 72% with the S&P 500 but only 33% to the Barclays U.S. Aggregate Bond Index. Credit risk is compounded by the liquidity risk embedded in the bonds, which can make it difficult for managers to sell bonds in stressed environments without making significant concessions on price. As a result, sell-offs like the one we've seen in high yield so far this month are not uncommon. The markets hit a similarly rough stretch in the first half of December 2014, when they suffered heavier losses than what we've seen through the same period in December 2015.

What should a high-yield investor do? It is important to take a long-term perspective when investing in junk bonds. Given the sector's higher correlation to stocks, investors should view high-yield bonds as long-term vehicles for income generation but not as a safe-haven asset. For those uncomfortable with the sector's risk profile, it is probably best to steer clear. Morningstar's Christine Benz points out that many institutional asset-allocation experts skip high-yield bonds altogether and argue they don't add anything to a portfolio that one can't get from stock and bond allocations.

For those who do invest in high yield, what are the key considerations? Look for well-resourced managers with proven track records who don't reach for yield. When Morningstar analysts evaluate high-yield funds, we favor managers who have demonstrated bond-picking skills through a variety of different market environments. Because success in high yield is driven in large part by security selection and avoiding permanent capital impairment via defaults, the size and experience of a firm's analyst staff is also important. In August, my colleague Sumit Desai highlighted a few of our favorite more-conservative picks.

On Monday, we’ll delve deeper into what has been driving the junk market’s troubles for the year to date.