Is there more liquidity danger in High Yield Bond Funds? Check with Durbin-Watson.

In the winter of 2015, an almost unheard of situation happened. A mutual fund, normally required to guarantee daily liquidity, blocked its clients from withdrawing money. The Third Ave Focused Credit Fund (TFCIX), citing losses and a lack of liquidity in the high yield bond market, put some of its assets into a trust to be sold over time.

For mutual funds that invest in illiquid assets, such as high yield bond funds, liquidity is a major concern. If too many investors try to cash out at the same time, to provide liquidity, a fund may be forced to sell its holdings at fire sale prices – if it can find a buyer at all. Fitch has forecast that $90 billion of high yield debt could default by year end, while S&P Global has forecast that the U.S. speculative grade default rate will climb to 5.3% by the end of 2017’s first quarter, up from 3.8% twelve months earlier. Furthermore, high yield debt’s recovery rate – or portion of principal and interest recovered in bankruptcy – was down to 34% in 2015, well below its historical average of 46% according to Lehmann Livian Fridson Advisors. More defaults with less recovered could set off panic bells for investors in high yield funds. Last September, the SEC even proposed permitting funds to adjust a fund’s redemption price to pass on the costs of immediate liquidity to redeeming shareholders. High yield bond investors could face a rocky ride ahead. If a fund is not able to sell investments quickly without taking a large loss, the ability of the fund to provide daily liquidity is compromised.