I’m writing this during the holiday season, so I thought I’d use Frank Capra’s brilliant film, It’s A Wonderful Life, to explain a concept.
If you’re not familiar with the film, IMDB (a great site for movie fans) provides a plot summary. George Bailey manages the Building and Loan started by his father. On Christmas Eve, Uncle Billy loses $8,000 he intended to deposit at the bank. Evil Mr. Potter finds the money and hides it.
The Bailey Building and Loan
Now, the movie scene I’ll use is when a bank examiner visits in the bank. We find out that Bailey Building and Loan has to have enough money on deposit to pay all of the deposits- should everyone withdraw their money at the same time.
No spoiler alert- watch the film to find out what happens! The movie asks a great question for the ages: what would the world be like if I never existed?
What’s a junk bond fund?
Now, there’s a connection between what happened at the Bailey Building and Loan and the recent collapse of the Third Avenue Focused Credit Fund.
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Bloomberg explains that this fund is a distressed bond fund. By distressed, we mean a mutual fund that invests in high-yield bonds, or junk bonds. Now, a few things you should know:
• There are several financial reasons why a company may have a low bond rating. If they don’t generate consistent earnings, they may not be able to make principal and interest payments. Maybe they already carry too much debt, which means that debt payments are more than they can handle. Finally, the issuing company may not have sufficient assets to serve as collateral for the loan.
• Companies with a low bond rating must, on average, pay a higher interest rate. That makes sense- they need to do something to compensate investors for taking more risk. That risk is that the issuer can’t make the payments, which is referred to as a bond default.
Investors buy these bonds to earn the higher interest rate. However, anyone buying a junk bond mutual fund needs to understand these basic concepts.
No one’s gonna buy your junk bond
In addition to the low credit ratings, junk bonds trade far less frequently than higher rated bonds. Think about the craps table at a casino. Lots of people bet on whether the next pair of dice roll will add up to 7. That bet has odds that are OK. However, far fewer people bet that both dice will come up with a 6. Those odds are much longer.
In the same way, far fewer people are interested in junk bonds. They trade less frequently. Less investor interest also means that the price you receive can be far different than the sale price that occurred on the last trade. Investors refer to junk bonds as being illiquid- lacking liquidity.
The smell of panic
Now, this is a problem if you manage a mutual fund. Like the Bailey Building and Loan, people may want to withdraw their money any business day. Well, what if a bunch of sellers show up? What price will you get when you need to sell bonds to pay investors?
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Also keep in mind that when a bunch of sell orders come in for bonds, people pay attention. Other junk bond investors will note the declining prices. Those other investors may want to sell, too. You may end up with junk bond investors selling out of panic as they see prices go down- which simply accelerates the process.
Stopping the flow out the door
The fund explained that the SEC granted the fund an ‘exemptive relief order”. This order allowed Third Avenue to suspend fund redemptions. Unlike the Building and Loan, investors could not liquidate their fund when this notice was released. Here’s why: this order “allows Third Avenue to conduct an orderly liquidation without having to resort to forced selling of securities at reduced or disadvantageous prices.”
In other words, this is an attempt to end any panic selling.
Steps you should take
If you own a bond fund, make sure that you clearly understand the average credit rating of the bonds in the portfolio. Consider whether of not you are comfortable with the risk you’re taking.
As always, consult a financial advisor- this blog is for education purposes only.
Does this information help you? I’d love to hear from you.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(website and blog) http://www.accountingaccidentally.com/
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Image: Christmas Tree (CC By 2.0)