Representatives from BlackRock met with SEC staff at the end of January regarding the SEC’s proposal on liquidity risk management and swing pricing. However, accompanying the typically sparse memo documenting the meeting was a “special report” produced by BlackRock entitled “High Yield Case Study: Post Closing of Third Avenue Focused Credit Fund.”
In the report, BlackRock argues that Third Avenue’s Focused Credit Fund (“FCF”) “was not a typical high yield open-end mutual fund,” but instead “was a concentrated distressed debt portfolio with significant investments in securities in default, pay-in-kind bonds, Lehman claims, Fannie and Freddie preferred stock, and securities that were otherwise restricted from trading.” BlackRock’s review of FCF’s portfolio found the fund to be much more concentrated, more invested in holdings with lower ratings and higher coupon rates with higher yields and more heavily discounted prices, and less liquid than other high yield open-end mutual funds. Additionally, BlackRock noted that FCF’s performance was significantly worse than Morningstar’s high yield bond category, ranking in the 99th percentile for YTD, 1 year, 3 year, and 5 year time periods.
Despite some predictions that FCF’s distress would spread to other high yield bond funds, BlackRock explained that “bonds of higher quality liquid issuers traded down a point or two, whereas lower quality, less liquid names dropped three to five points” at the height of volatility and selling pressure on Friday, December 11 (two days after FCF notified shareholders of the freeze on redemptions). BlackRock’s own high yield bond funds did not experience “material changes in flows following the Third Avenue announcement” and the peak flow in December for one of its funds actually occurred before FCF’s announcement.
According to BlackRock, the events surrounding the FCF issue provided a good look at how bond ETFs perform during market stress. BlackRock noted that high yield ETFs experienced record trading volumes just before the FCF announcement and that the ETFs traded an aggregate volume of $6.1 billion on December 11, a figure that was nearly 65 percent of the size of all over-the-counter high yield bonds for the day. The ability of high yield bond ETFs to weather this type of volatility demonstrated that they serve “as shock absorbers to activity in the asset class without putting stress on the underlying bond market,” according to the report.
BlackRock suggested that the experience of the events surrounding FCF, presents “an opportunity to test our hypotheses and to learn from the event.” While BlackRock has been critical of the SEC’s proposal on liquidity risk management, it did offer some suggested regulatory changes based on the FCF case study. It suggested that the SEC should reconsider its guidelines around fund classifications and naming conventions. The report also suggested that regulators should implement a tiered notification system regarding relative liquidity in funds so that regulators can better monitor the situation. Also, BlackRock suggested a requirement that a fund notify regulators and the fund’s board if the fund exceeded a threshold of illiquid portfolio holdings, specifically 15 percent. BlackRock suggested that these notifications should bring closer supervision from regulators, including daily updates from the fund; further, the report suggested that the enhanced supervision could be curtailed once the redemption/liquidity pressures eased.