Here’s a nice catch from Eric Balchunas and Athanasios Psarofagis at Bloomberg Intelligence last week: the Catalyst Interest Rate Opportunity Fund is about to shut down, after losing nearly 30 per cent of its net asset value in just one month.
The strategists argue that the Catalyst Fund could be a “canary in the coal mine” for bond funds:
We believe bond mutual funds may present the greatest systemic risk in the market: They may be in worse shape than they appear due to inflated net asset values that aren’t truly reflecting the depth of the downturn in bonds.
Spicy!
Now, it’s difficult to tell how “systemic” this risk is. It also isn’t clear whether the strategists are saying the fund’s value was purposefully “inflated” or if withdrawals started a doom loop/fire sale/etc. After their strongly worded opening, the strategists continue into more general commentary:
IOXIX is an isolated case for now, but if outflows persist for the vast majority of bond mutual funds, there could be more like it. Increased outflows would force bond mutual funds to sell bonds, further lowering prices and resulting in outsized markdowns to NAV, likely sparking more investor exits. Bond mutual funds have $414 billion in outflows in 2022 — their worst year since ICI began tracking the data in 2007. They’ve posted outflows almost every week this year, albeit in an orderly manner.
Indeed, there were withdrawals totalling nearly half the fund’s size in the span of just four weeks in September, according to EPFR. The problem with the fire-sale theory is that the Interest Rate Opportunities Fund was tiny; it only managed about $21mn at the start of this year (its September outflows added up to $10mn), and it looks pretty idiosyncratic.
The fund invests in US agency mortgage-backed securities and collateralised mortgage obligations, which aren’t especially liquid markets. But agency MBS aren’t necessarily the most illiquid bonds, either. At the index level, they’ve significantly outperformed long-dated Treasuries, down 10 per cent during USTs’ 30-per-cent slide.
But as BI writes, the fund did own some complex instruments like interest-only and inverse interest-only MBS in its portfolio of collateralised mortgage obligations. The yields on interest-only MBS, for example, often depend in part on prepayment rates and are probably not super easy for non-experts to mark, or for experts to sell in a pinch.
One interesting point left out of the BI note is that the fund changed subadvisers in mid-June. Catalyst switched from its original subadviser, called Stone Beach Investment Management, to Wynkoop Financial LLC, which manages another fund for Catalyst.
The Interest Rate Opportunities fund is much smaller than the other fund that Wynkoop subadvises (that’s the Catalyst Enhanced Income Strategy Fund, which has more than $500mn under management). So for a moment, it seemed like the fund closure could have effectively been a merger.
But that doesn’t explain the outflows.
Plus, when Wynkoop portfolio manager Leland Abrams wrote an update in the fund’s last annual report, on June 30 2022, it sounded like the company was in the middle of implementing a new strategy. From the report:
There may be a small ramp-up period to get fully invested since the fund had nearly 50% cash at the time of management transition.
After taking over management of the Fund on June 15, 2022, the new team has made some changes. We have cleaned up some legacy positions and reduced interest rate short hedges (Eurodollar futures contracts). We feel that now, the skew is towards lower rates on the long end of the curve and therefore, we have been rebuilding the portfolio with some investments that have an asymmetrical return profile going forward. CMOs priced in the $50s to $70s, which are ultimately government guaranteed bonds, exhibit positive convexity and the ability to out-earn as the interest rate cycle shifts some time next year. However, we have hedged that risk to some extent with some higher coupon agency interest-only securities. This way, we receive the benefit of positive carry driven partly by low prepayment due to the state of housing and current interest rates. We believe this combination could outperform the sector significantly over the coming 12-18 months.
Sounds interesting! So what happened??
Another point of interest: in the initial transition to Wynkoop from Stone Beach, portfolio manager Ed Smith initially continued with the fund. He left on July 6. Stone Beach is registered as an investment adviser with the SEC; in its latest ADV filing it said it had ~$21mn under management at the end of 2021, which is around the same amount as the Catalyst Interest Rate Opps fund.
The fund’s documents say it was originally created to manage the money of founder David Lysenko, who lists Renaissance Technologies as a former employer on his LinkedIn page. So it’s possible that he withdrew his own cash in the months after Smith left, and there wasn’t enough left to make it worth keeping open.
But why wait more than two months after Smith’s departure to do that? We have contacted Catalyst for comment, and sent Lysenko a message on LinkedIn and will update if or when we hear back.