Bond Investors Are Better Off in ‘Interval Funds.’ Here’s Why.

hank

Bond Investors Are Better Off in ‘Interval Funds.’ Here’s Why. - Lewis Braham

“In the world of bond funds, one major underappreciated risk is the liquidity imbalance that exists between funds and their shareholders. Traditional bond mutual funds and ETFs must provide their shareholders with daily liquidity—in other words, investors must be able to withdraw any part or all of their investment on any day. That’s a mismatch to what the funds own, such as bonds that can have maturities of up to 30 years, or bonds that don’t trade daily.”

By Lewis Braham, Barrons May 25, 2020
https://www.barrons.com/articles/bond-investors-are-better-off-in-interval-funds-heres-why-51590152400

(Good luck with above link. Better idea - Buy a copy of Barron’s or subscribe. Amazon lets you cancel digital subscriptions anytime.)


There seems to be an increasingly loud chorus of premonitions concerning bond funds of late. I’ve taken the liberty of adding a couple warning shots from two other seasoned observers. Notwithstanding: Lewis’s article is unique and approaches the issue from a different direction.


- - - Plague Investing - Ed Studzinski

“So, for your investable assets, I am sticking with my recommendation for a barbell strategy. For fixed income, limit yourselves to short-duration, short-maturity investments where the funds are managed by experts who have been doing real credit analysis for years. You can find them by paying attention to the reviews that David has written. These situations are to be differentiated from those fixed income funds run by generalists who did things based on rating spreads in quality rather than real analysis. They are nothing more than high-yield tourists.”

Edward Studzinski - Mutual Fund Observor May 3, 2020


- - - What You Don't See Might Be What You Get - Bill Fleckenstein

“ (For) those who have any bond funds, you have to be very careful unless they are all government bonds, because there's a lot of garbage in these funds and a lot of the credits -- which were probably overrated to begin with -- have certainly now deteriorated.

Thanks to one of our longtime readers, who runs a bond shop, and pointed out what happens when these funds see redemptions, which is that the most liquid bonds tend to get sold first, and they also tend to be the highest quality. In his words:

‘Without any change in investment strategy, such investors are left with a portfolio of assets that can be very different to the same portfolio at the time of investment … It is imperative for investors to ensure that they are not left in funds that are deteriorating in asset quality due to such redemptions.’

So, any of you in bond funds need to make darn sure that you know what you own. If you don't, it might be a good time to exit stage left.“

Fleckenstein Capital .com (Subscription Required) Excerpted from March 26, 2020 edition
https://www.fleckensteincapital.com/home.aspx


“In the tranquilly resounding corner, listening to the echoing footsteps of years” - Charles Dickens

Crash

@hank: I always pay attention when you write anything here. I did not ever even see the term "interval funds" before. So, I went looking. What Investopedia offers-up here doesn't sound like my cup of meat. Apologies to Bob Dylan.

Yes, ALL my investments are in open-ended funds. Portfolio is still 58% in bonds. I'm getting somewhere between 3.5 and 4.0% yield on them. https://www.investopedia.com/articles/investing/120516/what-interval-fund.asp

LewisBraham

While I prefer the structure of interval funds for illiquid bonds and other securities, unfortunately the fees and the leverage employed on the funds that currently exist are too high in my opinion. What this investment cateory needs is more competition--more funds to bring fees and leverage down. If a fund company were to launch an interval high yield or mortgage bond fund with reasonable fees and no leverage, I would be all ears. Here's looking at you Vanguard. Also, fees on all interval and closed-end funds should be charged net of leverage not gross of leverage. In fact, it would be preferable if they used no leverage at all.

sma3

@LewisBratham

In theory Closed End funds should be able to accomplish the same thing.
do you think CE funds can dodge the liquidity issue? I have had difficulty finding CE funds that are only high quality bonds and without much leverage

LewisBraham

CE funds can do the same thing, but the problem for some investors is they don't like the discounts they trade at to NAV. There is also an agency problem with CEs in that investors' capital is permanent and thus "trapped" in the fund unless investors are willing to accept the discounted price the CE's shares trade at on the market. Managers who are greedy for fees take advantage of the trapped capital and collect fees regardless whether the fund does well or poorly. The interval fund solves the problem by allowing shareholders to redeem their shares at their full underlying NAV value, albeit slowly--5% of assets per quarter--so it doesn't require much forced selling on the manager's part. Unfortunately, most regular CEs employ leverage too. Sometimes that works in a bull market. Other times it's disastrous. And many funds also collect fees on the leveraged assets, creating that conflict of interest where the manager is incentivized to employ leverage to collect fees on a larger asset base.

sma3

It is all about greed isn't it?

LewisBraham

@sma3 For most managers, unfortunately. There's a reason I think why investors called John Bogle St. Jack. He was far from perfect, but he took the term "fiduciary" seriously, and really meant it when he said he wanted to put clients first. But most managers don't do that.

sma3

Vanguard has had an increasingly mixed record with support snafus, mistakes and transparency issues. Their claim the "you own Vanguard" is a sham, as investors really dont have control over anything

LewisBraham

You are right that it isn't John Bogle's Vanguard anymore, and there are many problems. Yet they still are generally the low-cost provider in the fund world, especially in the actively managed fund world. Interval funds need to be "Vanguard-ed."

FD1000

I would never invest in a fund that I can't sell everything at any day.

Pimco https://www.pimco.com/en-us/investments/interval/flexible-credit-income-fund/inst performance isn't impressive at all at 0.37% annually for 3 years.

LewisBraham

@FD1000
https://investopedia.com/terms/l/liquiditypremium.asp

FD1000

LewisBraham said:

@FD1000
https://investopedia.com/terms/l/liquiditypremium.asp

I know the illiquidity of Interval Funds and why I would never invest in them.

hank

Personally, I enjoy reading articles like the one under discussion for the added insights into the workings of funds it conveys. So, I never view any particular fund approach being depicted by an author as “good”, “bad”, applicable or non-applicable to me. I just enjoy the extra depth of knowledge conveyed. In “Investing 101” some decades ago I learned that a “bond fund” is not a “bond.” They’re very different animals and behave differently. Pretty simple stuff. I assume most here who own bond funds understand that distinction.

What has changed is that 25 years ago prevailing rates were much higher. The manager had “wiggle room” to play the rate curve and grab off a decent return for his investors without taking great risk. But with rates as low as they are, managers are in a real bind and the risks of substantial loss (even on investment grade paper) are much higher today; while the potential return is paltry. That doesn’t even begin to address the complex rating issues for lower rated bonds. Nor does it address the substantial changes in trading habits that have evolved since the day when one called in his fund exchanges over the telephone (the corded variety).

LewisBraham

There is ample evidence that liquidity risks and a premium return for taking those risks exist in the bond market. Even if FDk-dude assumes he is avoiding illquidity by buying, say, the typical open-end high yield corporate bond or high yield municipal bond funds or ETFs, that doesn't mean the fund itself is avoiding those risks with the underlying securities it owns. He may in all likelihood be exposed to those risks inadvertantly only unable to reap the full or any illiquidity premium for taking those risks because shareholders panic during periods of stress. That is the point of interval funds.

msf

Interval funds have been getting a lot of press recently, giving people the impression that they're something new. While I was certain that they weren't, I was having problems finding a trace of them beyond the current publicity.

I finally ran across a breadcrumb from July 5, 2000:

Loan-participation funds, for instance, are different from most mutual funds because, for the most part, they don't allow investors to redeem fund shares any time they would like. Instead, most offer only quarterly windows for redemptions.

https://www.wsj.com/articles/SB962673584979225345

I believe these funds gradually "opened" up and evolved into bank loan funds. For example, the article mentions Eaton Vance Prime Rate Reserves (EVPRX). This was a continuously offered fund with quarterly redemptions. Here's a 2006 prospectus describing its operation. In 2008 it became the open end fund EAFAX with the same underlying portfolio.

ISTM that the term "interval fund" is of more recent vintage. Effectively, so-called interval funds are version 2.0.

LewisBraham

No, interval funds are not new by any means. We just need better lower-fee unleveraged ones than those that currently exist.

carew388

ISTR that Michael Price had discussed starting an interval fund in the 1990's to invest in distressed companies and high yield bonds. Unfortunately, ZEOIX has morphed into an interval fund for me as I'm not willing to take a $500 loss(at least for now.)