What do bond funds do when issuers go bankrupt?

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000
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What do bond funds do when issuers go bankrupt?

Post by 000 »

I know that bondholders get equity but I'm curious how bond funds handle this case.

I suppose some sell the bonds when they reach a certain credit floor but do other funds hold on to the end and then sell the new equities right away?

Is there any fund out there that's a good way to take a "I think bankruptcies are coming and want to be the new stockholder" position?
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Re: What do bond funds do when issuers go bankrupt?

Post by arcticpineapplecorp. »

the three characteristics of a bond fund you should look for is:
1. high quality
2. short to intermediate
3. index so you're guaranteed to get the return of the bond market

if you hold these characteristics, there should be little default risk, so the question is moot.

if you're asking about more risky (high yield, aka junk bonds) handle these risks, I believe they either get out before the worst of it even if taking a haircut, or they en masse take a haircut...greek bonds come to mind wherein those bonds were paying over 8% in 2010 or 2011 if memory serves, right up until they were going to default entirely. The bondholders struck a deal with the greek government if memory serves to accept a payback of 50% of the par value of their bonds.

these are just my guesses.

look at the prospectus of the high yield corporate bond fund:
To minimize credit risk, the Fund normally diversifies its holdings among debt of at least 100 issuers, representing many industries. As of January 31, 2021, the Fund held debt of 239 issuers.This diversification should lessen the negative impact on the Fund of a particular issuer’s failure to pay either principal or interest.

https://personal.vanguard.com/pub/Pdf/p ... 2210142560
and for total bond market index fund:
Credit risk, which is the chance that a bond issuer will fail to pay interest or principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Credit risk should be low for the Fund because it purchases only bonds that are of investment-grade quality.

https://personal.vanguard.com/pub/Pdf/p ... 2210171760
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Re: What do bond funds do when issuers go bankrupt?

Post by alex_686 »

000 wrote: Sun Sep 05, 2021 2:35 pm I know that bondholders get equity but I'm curious how bond funds handle this case.
Generally speaking they sell. Most prospectuses limited the amount of junk bonds in their portfolio. Statue requires that public funds keep most of their assets in liquid assets. Bankrupt bonds are not. There is a strong incentive to get these off the books.
000 wrote: Sun Sep 05, 2021 2:35 pm Is there any fund out there that's a good way to take a "I think bankruptcies are coming and want to be the new stockholder" position?
This would be a poor strategy. Bond prices tend to crash hard after a bankruptcy. There is a long period between bankruptcy and reorganization. The outcome is uncertain. Bankruptcy court requires the manager to be a active negotiator. Public funds don't the time or specialized resources to do this. This is called "J Risk", because the outcome is so heavily dependent on the court. a.k.a. "Justice System", hence "J Risk".

The normal mutual fund strategy is to buy junk bonds in companies that will improve in the future.

There are specialized hedge and private equity funds that do this. They have long lock-up periods due to the liquidity nature. They have bankruptcy specialized on staff.
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Re: What do bond funds do when issuers go bankrupt?

Post by nisiprius »

Mutual funds are required to provide daily liquidity. That means that they are supposed to invest almost all of their money into highly liquid holdings, to avoid the mismatch of trying to create a liquid silk purse from an illiquid sow's ear. That makes it difficult for mutual funds to invest in distressed bonds.

I don't know whether it fit your description of "a fund... that's a good way to take a 'I think bankruptcies are coming and want to be the new stockholder.'" But you should certainly read up on what happened to the Third Avenue Focused Credit fund. It invested in distressed and defaulted bonds. Although people called it a "high-yield bond fund" the average credit rating was far, far lower than any normal "high-yield" bond fund. I believe it was below a C.

It collapsed completely. It didn't manage the liquidation gracefully. It didn't work the way mutual funds are supposed to work.

Third Avenue Focused Credit Abruptly Shuttered
The fund's management team, led by Tom Lapointe, invested heavily in illiquid bonds. Then, when the fund's performance deteriorated and shareholders asked for their money back, the team found itself unable to sell those bonds without unloading them at fire sale prices.
The author of that Morningstar piece says the fund was "mismanaged."

I would suggest that this is an area of investing that requires very specialized expertise, no matter how you choose to invest in it. In this case, the security blanket of the Investment Act of 1940 was not enough to protect investors.
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
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Re: What do bond funds do when issuers go bankrupt?

Post by Valuethinker »

000 wrote: Sun Sep 05, 2021 2:35 pm I know that bondholders get equity but I'm curious how bond funds handle this case.

I suppose some sell the bonds when they reach a certain credit floor but do other funds hold on to the end and then sell the new equities right away?

Is there any fund out there that's a good way to take a "I think bankruptcies are coming and want to be the new stockholder" position?
It's not necessarily the case that bondholders get equity. If they do, it's usually at a huge discount (dilution).

Michael Price's Mutual Shares mutual fund did this for decades, along with other "value" strategies. Eventually there got to be enough other players in the market (hedge funds primarily) that the excess returns dried up, and the fund was wound up, I believe.

There's a distinguished history of companies going through Chapter 11 more than once. Airlines for example. Some industries have just terrible economics - and investors never seem to price that risk appropriately.
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Re: What do bond funds do when issuers go bankrupt?

Post by alex_686 »

000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Why? If we are talking about investment then the impact is very low. The downgrading from investment to junk has a much bigger impact.
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Re: What do bond funds do when issuers go bankrupt?

Post by JackoC »

000 wrote: Sun Sep 05, 2021 2:35 pm I know that bondholders get equity but I'm curious how bond funds handle this case.

I suppose some sell the bonds when they reach a certain credit floor but do other funds hold on to the end and then sell the new equities right away?

Is there any fund out there that's a good way to take a "I think bankruptcies are coming and want to be the new stockholder" position?
There are basically three things you can do with a bond of decreasing credit rating or perceived credit quality:
1. Sell it at a ratings or subjective quality floor. For the most part investment grade bond funds do this, for bonds which get downgraded to below investment grade. Therefore they relatively rarely hold defaulted bonds (it's not extremely unlikely eg. a A bond will default eventually but among those which do, it's unusual for them not to have been downgraded below BBB-, to 'junk', first). Although, the losses they take on selling downgraded bonds is a major reason the historical return of investment grade corporate bond index funds is not nearly as much higher than comparable treasury funds as the spread in yields, it's a bigger reason than direct defaults.

2. Sell on default. There is a market for defaulted bond, the buyers are investors specializing in distressed debt. Regular bond mutual funds are not in this business and generally sell bonds soon after default if they didn't previously.

3. Hold on through the bankruptcy process to either a restructured company with the former creditors now the equity holders (typically), or liquidation. Again regular corporate bond funds, even junk funds, don't typically do this. It can take years, for one thing.
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

alex_686 wrote: Mon Sep 06, 2021 9:58 am
000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Why? If we are talking about investment then the impact is very low. The downgrading from investment to junk has a much bigger impact.
I don't like that there is a "now we have to panic sell" condition. Not as simple as buy and hold.
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Re: What do bond funds do when issuers go bankrupt?

Post by EverydayWallSt »

000 wrote: Sun Sep 05, 2021 2:35 pm I know that bondholders get equity but I'm curious how bond funds handle this case.
This often isn’t the case. Many times, in an in-court or out-of-court restructuring (it’s a “bankruptcy” in court but can be a “restructuring” in out of court), bonds get nothing. They could easily be out of the money if there’s a lot of secured debt (e.g., revolver, 1st / 2nd lien term loans, etc.). Bonds are unsecured debt.
Last edited by EverydayWallSt on Wed Sep 08, 2021 9:51 pm, edited 1 time in total.
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

EverydayWallSt wrote: Wed Sep 08, 2021 5:51 pm This often isn’t the case. Many times, in an in-court or out-of-court restructuring (it’s a “bankruptcy” in court but can be a “restructuring” in our our), bonds get nothing. They could easily be out of the money if there’s a lot of secured debt (e.g., revolver, 1st / 2nd lien term loans, etc.). Bonds are unsecured debt.
Good point.
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Re: What do bond funds do when issuers go bankrupt?

Post by Stinky »

nisiprius wrote: Sun Sep 05, 2021 6:33 pm Mutual funds are required to provide daily liquidity. That means that they are supposed to invest almost all of their money into highly liquid holdings, to avoid the mismatch of trying to create a liquid silk purse from an illiquid sow's ear. That makes it difficult for mutual funds to invest in distressed bonds.

I don't know whether it fit your description of "a fund... that's a good way to take a 'I think bankruptcies are coming and want to be the new stockholder.'" But you should certainly read up on what happened to the Third Avenue Focused Credit fund. It invested in distressed and defaulted bonds. Although people called it a "high-yield bond fund" the average credit rating was far, far lower than any normal "high-yield" bond fund. I believe it was below a C.

It collapsed completely. It didn't manage the liquidation gracefully. It didn't work the way mutual funds are supposed to work.

Third Avenue Focused Credit Abruptly Shuttered
The fund's management team, led by Tom Lapointe, invested heavily in illiquid bonds. Then, when the fund's performance deteriorated and shareholders asked for their money back, the team found itself unable to sell those bonds without unloading them at fire sale prices.
The author of that Morningstar piece says the fund was "mismanaged."

I would suggest that this is an area of investing that requires very specialized expertise, no matter how you choose to invest in it. In this case, the security blanket of the Investment Act of 1940 was not enough to protect investors.
Nisiprius, what a great fount of knowledge you are.

I had never heard of Third Avenue Focused Credit. I clicked on the link provided above, and read the fascinating article.

I feel like I learned something today. :D
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Re: What do bond funds do when issuers go bankrupt?

Post by secondopinion »

000 wrote: Wed Sep 08, 2021 5:42 pm
alex_686 wrote: Mon Sep 06, 2021 9:58 am
000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Why? If we are talking about investment then the impact is very low. The downgrading from investment to junk has a much bigger impact.
I don't like that there is a "now we have to panic sell" condition. Not as simple as buy and hold.
Which one is true?
  • If overreaction is the norm, then on average it is more profitable to buy those "fallen angels" than the investment-grade; you now have a alpha generating strategy in comparison to the investment-grade fund (risk-adjusted is another subcase to consider).
  • If the reaction is actually an under-reaction usually, then the bond fund did the right thing for returns and not just risk management.
  • If the reaction is well-priced normally, then it is not a problem that the bond fund cuts its risk.
"Investment-grade" is a funny term when one thinks about it; after all, some investors invest in bonds that are not "investment-grade". Given how many BB and even B bonds actually survive, it is not like a lottery either. So, the term is a misnomer in all honesty.
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

secondopinion wrote: Wed Sep 08, 2021 6:30 pm Which one is true?
  • If overreaction is the norm, then on average it is more profitable to buy those "fallen angels" than the investment-grade; you now have a alpha generating strategy in comparison to the investment-grade fund (risk-adjusted is another subcase to consider).
  • If the reaction is actually an under-reaction usually, then the bond fund did the right thing for returns and not just risk management.
  • If the reaction is well-priced normally, then it is not a problem that the bond fund cuts its risk.
"Investment-grade" is a funny term when one thinks about it; after all, some investors invest in bonds that are not "investment-grade". Given how many BB and even B bonds actually survive, it is not like a lottery either. So, the term is a misnomer in all honesty.
Different cases could be true depending on the specific circumstance. One thing that seems likely to be true is that a passive fund with a mandate to panic sell whose managers don't have bankruptcy expertise is probably getting a worse deal selling downgraded bonds than the buyer.
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Re: What do bond funds do when issuers go bankrupt?

Post by arcticpineapplecorp. »

000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Bonds are for safety not growth. They're not supposed to be risky. That's what your stocks are for which leads to growth.

Stocks help you eat well. Bonds help you sleep well.
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Re: What do bond funds do when issuers go bankrupt?

Post by secondopinion »

000 wrote: Wed Sep 08, 2021 7:00 pm
secondopinion wrote: Wed Sep 08, 2021 6:30 pm Which one is true?
  • If overreaction is the norm, then on average it is more profitable to buy those "fallen angels" than the investment-grade; you now have a alpha generating strategy in comparison to the investment-grade fund (risk-adjusted is another subcase to consider).
  • If the reaction is actually an under-reaction usually, then the bond fund did the right thing for returns and not just risk management.
  • If the reaction is well-priced normally, then it is not a problem that the bond fund cuts its risk.
"Investment-grade" is a funny term when one thinks about it; after all, some investors invest in bonds that are not "investment-grade". Given how many BB and even B bonds actually survive, it is not like a lottery either. So, the term is a misnomer in all honesty.
Different cases could be true depending on the specific circumstance. One thing that seems likely to be true is that a passive fund with a mandate to panic sell whose managers don't have bankruptcy expertise is probably getting a worse deal selling downgraded bonds than the buyer.
Then buy some of the "fallen angels"; I would not limit my scopes to "investment-grade" only.
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

arcticpineapplecorp. wrote: Wed Sep 08, 2021 7:33 pm
000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Bonds are for safety not growth. They're not supposed to be risky. That's what your stocks are for which leads to growth.

Stocks help you eat well. Bonds help you sleep well.
I'm not sure. Corporate bonds seem plenty risky to me. Mass bankruptcies seem plausible in a major economic / financial correction which would lead to your safe bonds being panic sold.
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Re: What do bond funds do when issuers go bankrupt?

Post by UpperNwGuy »

000 wrote: Wed Sep 08, 2021 5:42 pm
alex_686 wrote: Mon Sep 06, 2021 9:58 am
000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Why? If we are talking about investment then the impact is very low. The downgrading from investment to junk has a much bigger impact.
I don't like that there is a "now we have to panic sell" condition. Not as simple as buy and hold.
When has that happened in our investing lifetimes?
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

UpperNwGuy wrote: Wed Sep 08, 2021 7:52 pm When has that happened in our investing lifetimes?
The last mass default event in the US was probably great depression and the various panics and crashes before that. But in the highly levered and frail (i.e. just in time supply chains) environment today it seems a plausible risk that can't be solved in a passive way.
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Re: What do bond funds do when issuers go bankrupt?

Post by arcticpineapplecorp. »

000 wrote: Wed Sep 08, 2021 7:46 pm
arcticpineapplecorp. wrote: Wed Sep 08, 2021 7:33 pm
000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Bonds are for safety not growth. They're not supposed to be risky. That's what your stocks are for which leads to growth.

Stocks help you eat well. Bonds help you sleep well.
I'm not sure. Corporate bonds seem plenty risky to me. Mass bankruptcies seem plausible in a major economic / financial correction which would lead to your safe bonds being panic sold.
what corporate bonds? short term corporate? long term corporate? You can't put them all in the same basket as if they're the same. They're not. That's why they're different funds.

and isn't that risk and return fundamental law of investing again? Take a look at the chart below. It compares total stock index to three bond funds for 2020 to show how different funds did during a period of risk: total bond index, intermediate corporate and short term corporate. I didn't include long term corporate because I don't think long term bonds are generally recommended.

Just showing total stock market so you can see that even when you're looking at risk with bonds, it's nothing compared to risk with stocks, right?

when you compare intermediate corporate with the other bonds (short term and total bond market) that fund was more risky than the other two. And the return for that risk was higher.

But total bond had higher return and less risk than short term corporate.

Image

source:
https://www.portfoliovisualizer.com/bac ... ion3_3=100

total bond market index fund contains corporates and government, not one or the other. I'd say it did the job fairly well last year, in terms of risk relative to corporates, even though the fund contained corporates.
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Re: What do bond funds do when issuers go bankrupt?

Post by UpperNwGuy »

000 wrote: Wed Sep 08, 2021 8:06 pm
UpperNwGuy wrote: Wed Sep 08, 2021 7:52 pm When has that happened in our investing lifetimes?
The last mass default event in the US was probably great depression and the various panics and crashes before that. But in the highly levered and frail (i.e. just in time supply chains) environment today it seems a plausible risk that can't be solved in a passive way.
I don't consider it to be a likely risk, so I will continue to hold my intermediate corporate bond fund.
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Re: What do bond funds do when issuers go bankrupt?

Post by secondopinion »

arcticpineapplecorp. wrote: Wed Sep 08, 2021 8:09 pm
000 wrote: Wed Sep 08, 2021 7:46 pm
arcticpineapplecorp. wrote: Wed Sep 08, 2021 7:33 pm
000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Bonds are for safety not growth. They're not supposed to be risky. That's what your stocks are for which leads to growth.

Stocks help you eat well. Bonds help you sleep well.
I'm not sure. Corporate bonds seem plenty risky to me. Mass bankruptcies seem plausible in a major economic / financial correction which would lead to your safe bonds being panic sold.
what corporate bonds? short term corporate? long term corporate? You can't put them all in the same basket as if they're the same. They're not. That's why they're different funds.

and isn't that risk and return fundamental law of investing again? Take a look at the chart below. It compares total stock index to three bond funds for 2020 to show how different funds did during a period of risk: total bond index, intermediate corporate and short term corporate. I didn't include long term corporate because I don't think long term bonds are generally recommended.

Just showing total stock market so you can see that even when you're looking at risk with bonds, it's nothing compared to risk with stocks, right?

when you compare intermediate corporate with the other bonds (short term and total bond market) that fund was more risky than the other two. And the return for that risk was higher.

But total bond had higher return and less risk than short term corporate.

...
Only for that sliver of time were short term corporates more volatile than the total bond market. Short term corporate bonds usually are less volatile than the total bond market by 30% or so. However, the total bond market has had better returns usually; so, risk for return is maintained.

Long-term bonds have an esoteric purpose in a portfolio; most people cannot effective benefit from them (at least in amounts much more than the total bond market). But remember, short-term bonds are investable for both short or longer terms; long-term bonds are investable for longer terms only, as short timeframes act more like a rate speculation.
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Re: What do bond funds do when issuers go bankrupt?

Post by arcticpineapplecorp. »

secondopinion wrote: Thu Sep 09, 2021 12:49 pm
arcticpineapplecorp. wrote: Wed Sep 08, 2021 8:09 pm
000 wrote: Wed Sep 08, 2021 7:46 pm
arcticpineapplecorp. wrote: Wed Sep 08, 2021 7:33 pm
000 wrote: Sun Sep 05, 2021 11:17 pm I guess that makes sense, but it makes (corporate) bond funds even less attractive to me.
Bonds are for safety not growth. They're not supposed to be risky. That's what your stocks are for which leads to growth.

Stocks help you eat well. Bonds help you sleep well.
I'm not sure. Corporate bonds seem plenty risky to me. Mass bankruptcies seem plausible in a major economic / financial correction which would lead to your safe bonds being panic sold.
what corporate bonds? short term corporate? long term corporate? You can't put them all in the same basket as if they're the same. They're not. That's why they're different funds.

and isn't that risk and return fundamental law of investing again? Take a look at the chart below. It compares total stock index to three bond funds for 2020 to show how different funds did during a period of risk: total bond index, intermediate corporate and short term corporate. I didn't include long term corporate because I don't think long term bonds are generally recommended.

Just showing total stock market so you can see that even when you're looking at risk with bonds, it's nothing compared to risk with stocks, right?

when you compare intermediate corporate with the other bonds (short term and total bond market) that fund was more risky than the other two. And the return for that risk was higher.

But total bond had higher return and less risk than short term corporate.

...
Only for that sliver of time were short term corporates more volatile than the total bond market. Short term corporate bonds usually are less volatile than the total bond market by 30% or so. However, the total bond market has had better returns usually; so, risk for return is maintained.

Long-term bonds have an esoteric purpose in a portfolio; most people cannot effective benefit from them (at least in amounts much more than the total bond market). But remember, short-term bonds are investable for both short or longer terms; long-term bonds are investable for longer terms only, as short timeframes act more like a rate speculation.
yeah i was actually surprised to see that a short term bond fund (corporate albeit) did worse than the total bond market (an intermediate). that's not why i chose the time period. I was just looking at a large drop in the market and to show that short term bonds generally do better than intermediate, longer term or stocks.

the OPs comments were that corporates are scary, but short term should be less scary and diversifying between corporates and gov (as in total bond index) is less scary still.
It's hard to accept the truth when the lies were exactly what you wanted to hear. Investing is simple, but not easy. Buy, hold & rebalance low cost index funds & manage taxable events. Asking Portfolio Questions | Wiki
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Re: What do bond funds do when issuers go bankrupt?

Post by secondopinion »

arcticpineapplecorp. wrote: Thu Sep 09, 2021 12:57 pm
secondopinion wrote: Thu Sep 09, 2021 12:49 pm
arcticpineapplecorp. wrote: Wed Sep 08, 2021 8:09 pm
000 wrote: Wed Sep 08, 2021 7:46 pm
arcticpineapplecorp. wrote: Wed Sep 08, 2021 7:33 pm
Bonds are for safety not growth. They're not supposed to be risky. That's what your stocks are for which leads to growth.

Stocks help you eat well. Bonds help you sleep well.
I'm not sure. Corporate bonds seem plenty risky to me. Mass bankruptcies seem plausible in a major economic / financial correction which would lead to your safe bonds being panic sold.
what corporate bonds? short term corporate? long term corporate? You can't put them all in the same basket as if they're the same. They're not. That's why they're different funds.

and isn't that risk and return fundamental law of investing again? Take a look at the chart below. It compares total stock index to three bond funds for 2020 to show how different funds did during a period of risk: total bond index, intermediate corporate and short term corporate. I didn't include long term corporate because I don't think long term bonds are generally recommended.

Just showing total stock market so you can see that even when you're looking at risk with bonds, it's nothing compared to risk with stocks, right?

when you compare intermediate corporate with the other bonds (short term and total bond market) that fund was more risky than the other two. And the return for that risk was higher.

But total bond had higher return and less risk than short term corporate.

...
Only for that sliver of time were short term corporates more volatile than the total bond market. Short term corporate bonds usually are less volatile than the total bond market by 30% or so. However, the total bond market has had better returns usually; so, risk for return is maintained.

Long-term bonds have an esoteric purpose in a portfolio; most people cannot effective benefit from them (at least in amounts much more than the total bond market). But remember, short-term bonds are investable for both short or longer terms; long-term bonds are investable for longer terms only, as short timeframes act more like a rate speculation.
yeah i was actually surprised to see that a short term bond fund (corporate albeit) did worse than the total bond market (an intermediate). that's not why i chose the time period. I was just looking at a large drop in the market and to show that short term bonds generally do better than intermediate, longer term or stocks.

the OPs comments were that corporates are scary, but short term should be less scary and diversifying between corporates and gov (as in total bond index) is less scary still.
Personally, not even the long-term corporates are scary. Each to their own risk tolerance. Of course, I speculated and bought corporate bonds at their low during that time with some of my long-term treasuries. (It was triggered by a 10+% drop in FLOT, a floating rate corporate bond fund [which was even suggested to be an alternative to a money market fund once by an "all-knowing" article].). Again, risk tolerance of mine is probably too high during bears.
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Re: What do bond funds do when issuers go bankrupt?

Post by BJJ_GUY »

000 wrote: Sun Sep 05, 2021 2:35 pm I know that bondholders get equity but I'm curious how bond funds handle this case.

I suppose some sell the bonds when they reach a certain credit floor but do other funds hold on to the end and then sell the new equities right away?

Is there any fund out there that's a good way to take a "I think bankruptcies are coming and want to be the new stockholder" position?
Most of the replies above pretty much cover the main answers to your question. Here is what I'd highlight:

Mutual funds are not a good structure to invest in distressed assets. Duration is the friend of distressed debt investors, not because they want a re-organization (or liquidation) to drag-on, but because it allows them to buy assets at attractive prices, and a longer time frame allows the creditor to avoid being squeezed by other creditors, private equity sponsors, and the borrower.

The way distressed debt (private) funds benefit is in large part due to uneconomic selling on behalf of mutual funds, banks, public funds etc. This is different from the value proposition available to a mutual fund who already owns the debt (so they are limited to hold or sell... compared to private funds who can be disciplined about their entry point, and exactly what part of the capital stack to buy etc.)

As an aside, just to clarify a comment made previously, debt holders of a company going through a re-organization (regardless of in court or out) are not compelled to be active members of an official steering committee. There are a lot of funds who do well trailing the coat-tails of the better equipped firms to lead negotiations and planning. A relatively small stake in the capital structure and remaining passive allows for an easier exit once the debt-for-equity transfer takes place (not constrained by the level of trade restrictions as other groups).

Finally, the analogy between corporate credit bankruptcies and sovereign defaults is only partially accurate. Sovereigns can't swap equity-for-debt, so they kind of have to beg creditors to accept a hair cut (albeit often with some nice perks for those skilled at negotiating). Corporate restructurings have many more levers to pull.

I'd be remiss if not to point out that this is the reason hedge funds don't offer better liquidity to investors. Also, you often read/hear people criticize this gating mechanism as a bad thing, and refer to side-pocketing as near-evil in intent. Truth is, these mechanisms allow the strategy to work, and provide equity amongst the investors in the fund. (If Third Avenue could have side-pocketed even 1 or 2 of the issuers bonds that got illiquid, they may have been able to survive.)
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000
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

Follow up question to all the knowledgeable and helpful posters here:

What outcome will an individual investor holding an individual corporate bond see during a bankruptcy event? Would the individual be able to hold out to the end and partake in the settlement passively or would active involvement be required?
BogleFan510
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Re: What do bond funds do when issuers go bankrupt?

Post by BogleFan510 »

000 wrote: Wed Oct 20, 2021 7:34 pm Follow up question to all the knowledgeable and helpful posters here:

What outcome will an individual investor holding an individual corporate bond see during a bankruptcy event? Would the individual be able to hold out to the end and partake in the settlement passively or would active involvement be required?
There is no pat answer as every insolvancy is unique. Sometimes there are assets to disperse, sometime not.
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

Let's suppose there are assets. Would the individual investor just passively sail through that like a class action?
BJJ_GUY
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Re: What do bond funds do when issuers go bankrupt?

Post by BJJ_GUY »

000 wrote: Wed Oct 20, 2021 8:54 pm Let's suppose there are assets. Would the individual investor just passively sail through that like a class action?
I don't know the technical answer as far as how passive you can be. For example, if in bankruptcy, at some point, once the creditors agree on a plan, the debt holder has to agree to the plan. So you can't be fully passive, at least I don't believe.

If you own the bonds there is a good chance that a bankruptcy would be a restructuring and not a liquidation. In a restructuring what you receive all depends on the value of the business and what that value means in relation to the capital structure.

For example, think of a simple capital structure where you have the senior secured debt, bonds (unsecured), and equity. The creditor committees (official and ad hoc) for each debt piece, negotiate on your behalf (since you own bonds), and if you are senior to the fulcrum security, you are in the money. If the financial condition is such that the equity is worthless, they get zero. Often times part, or all, of the debt is exchanged for new equity (re-organized equity), and sometimes debt can be exchanged for new debt as well as some different debt instruments with bells and whistles which are offered in exchange for additional bridge financing to make it through the bankruptcy process.

Bottom line: If you're bonds are determined to have value, then you would just have to accept the plan that was negotiated by the unsecured credit committee to participate in exchange, however that might look.
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Re: What do bond funds do when issuers go bankrupt?

Post by alex_686 »

The default recovery rate for CDS and CDX swaps is 60% for investment grade bonds and 40% for high yield.

Take that with a high grain of salt. It may take years to resolve. Huge number of unknowns.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

Thanks for the answers.
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Re: What do bond funds do when issuers go bankrupt?

Post by Valuethinker »

The depth of knowledge in this Forum always amazes me.

Thank you to all posters in this thread for the enlightenment.
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Re: What do bond funds do when issuers go bankrupt?

Post by BJJ_GUY »

Valuethinker wrote: Thu Oct 21, 2021 3:05 am The depth of knowledge in this Forum always amazes me.

Thank you to all posters in this thread for the enlightenment.
Topics like these are interesting, fun, and educational. To the extent I have knowledge to share, I'm happy to take the time to post about new/fresh concepts.

Anything to avoid another discussion about factor tilting, valuations & predictive ability, and how interest rates will or won't impact bond funds! :beer
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Re: What do bond funds do when issuers go bankrupt?

Post by 000 »

Valuethinker wrote: Thu Oct 21, 2021 3:05 am The depth of knowledge in this Forum always amazes me.

Thank you to all posters in this thread for the enlightenment.
+1000

You said it best. :sharebeer
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