Third Avenue Management’s Focused Credit Fund shocked investors last week when it suspended cash redemptions and placed its assets in a trust for an orderly liquidation over time. In April, the fund began receiving a series of monthly outflows that became increasingly large during the second half of the year. These outflows would have required the immediate sale of assets on a large scale, which would have resulted in significant losses.

While Third Avenue’s collapse was surprising, it’s important to note that the fund wasn’t a run-of-the-mill high-yield mutual fund. The Focused Credit Fund was primarily focused on companies undergoing restructuring or bankruptcy, which places it squarely in the “distressed debt” category of mutual and hedge funds. According to Barron’s, the fund held nearly three times the number of unrated or CCC-rated bonds than its peer group.

The equity market fell more than 300 points on the day the fund announced its liquidation amid worries that rising interest rates and defaults may cause a junk bond liquidity crisis. While low-quality companies are holding record levels of debt, it may be premature to assume that these companies will default in high enough numbers to create a liquidity crisis. Investors should, however, take the opportunity to re-evaluate their portfolios for potential exposure.

Avoid Distressed Debt

Mutual fund investors should probably avoid distressed debt mutual funds altogether since they trade in some of the most illiquid bonds in the market. Since these bonds don’t regularly trade, it’s difficult for investors to determine their fair value and consequently value the mutual fund. The illiquidity also makes it difficult to handle large amounts of redemptions and may prompt a liquidity crisis like the one experienced by Third Avenue.

Billionaire investor Carl Icahn has already warned investors of the potential dangers of these illiquid high-yield securities, saying that they could accelerate a sell off in a stressed market by trading more rapidly than the underlying securities. While most mutual funds remain intact given their focus on safer high-yield debt, investors should keep these dynamics in mind for funds that hold large amounts of riskier debt.

New SEC Regulations

The Third Avenue crisis has prompted new guidelines from the SEC that may impact a number of mutual fund investors in several different ways.

The SEC is planning to force fund managers to develop formal plans for their liquidity. These plans may include provisions that would enable funds to charge fees to investors that sell in periods of market stress. While these laws aren’t likely to take effect until 2017 at the earliest, they mark a significant change in the way that investors can buy and sell shares in a mutual fund, but should also help improve transparency.

In addition to these rules, the agency is still pushing through a number of other key changes for the industry. The 2010 Dodd-Frank law, for example, requires extensive stress testing for large mutual funds in order to ensure that they can handle financial shocks. With Third Avenue’s Focused Credit Fund liquidation, the adoption of these new regulations could be put on an accelerated timetable to ensure the problems don’t arise again.

The Bottom Line

Third Avenue’s liquidation of its Focused Credit fund comes as many riskier high-yield junk bonds are facing troubles with rising interest rates and a growing number of defaults. While the fund is likely to be an isolated case, investors may want to consider avoiding distressed debt altogether and keep an eye on upcoming SEC regulations that could impose fees on investors that sell shares of certain mutual funds during times of crisis.