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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.
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.
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.
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