OREANDA-NEWS. The 10 largest US high-yield open-end funds have widely varying liquidity qualities, says Fitch Ratings. Investors redeemed several billion dollars' worth of shares in US high-yield bond funds following the Third Avenue Focused Credit Fund's redemption halt in December, highlighting the importance of assessing liquidity risks within mutual funds. Third Avenue was an outlier in the percentage of less liquid assets held in its portfolio and is not representative of other high-yield open-end bond funds.

The transparency of mutual funds' liquidity is limited and subjective. Managers are not required to disclose estimates of the percentage of illiquid securities, and the optimal determinants of liquidity remain subject to study and debate.

Fitch examined two metrics as proxies for fund liquidity: percentage of assets valued based on unobservable inputs or internal fair-value assessments (known as Level 3 valuations), and a fund's investments in low-rated or unrated securities. We found wide variations in these measures in the 10 largest US high-yield bond funds, which manage approximately $111 billion.

Within this sample, Level 3 assets ranged between 0% and 17% (using data from latest filings for each fund) with a median of 2%. Investments in Level 3 securities in the funds were generally in corporate bonds and loans, with a small percentage in asset-backed securities. Third Avenue's Focused Credit Fund, by comparison, classified approximately 24% of the fund's assets as Level 3 as of Oct. 31, 2015.

Within Fitch's 10-fund group, the median portion of the funds' assets rated 'CCC' or below, or not rated at all, was 19%, and ranged between 6% and 53% for funds with very few holdings in the unrated category. For Focused Credit Fund, 48% of its investments were in holdings rated 'CCC' and below, and 41% were in unrated securities, totaling 89% of assets as of Nov. 30, 2015, just prior to the fund's closure. Lower rated bonds generally fall in value farther and faster than higher rated securities during times of stress (a contributing factor to Third Avenue's losses). For example, between June and December 2015, bonds rated 'CCC' fell in value 25%, while bonds rated 'B' fared somewhat better, declining 12%, according to BofA Merrill Lynch Global Research.

Third Avenue's and other funds' liquidity profiles may have differed before and after the reporting dates Fitch reviewed, based on fund inflows or outflows, market value changes and portfolio reallocation.

The SEC launched a review of potential liquidity risks posed by high-yield funds following the Focused Credit Fund event. Even prior to the closure of the Third Avenue fund, regulators were growing increasingly concerned about liquidity risk, with the SEC proposing comprehensive liquidity management rules for mutual funds and ETFs in September 2015. Liquidity in fixed-income markets has declined at the same time that fixed-income issuance and fund holdings have expanded. The SEC's proposal includes classification of the liquidity of a fund's assets, procedures for the management of a fund's liquidity risk, and establishment of a three-day liquid asset minimum.