And the next crisis hasn’t even begun yet.

We have warned about “open-end” bond mutual funds, particularly those with a lot of high-yield bonds. We know some folks who got burned when Charles Schwab’s $13-billion bond fund SWYSX blew up during the financial crisis and lost 60% or so of its value before its data went offline.

Schwab settled all kinds of class-action and individual lawsuits for cents on the dollar. It got in trouble over other bond funds. And other purveyors of bond funds got in trouble too.

It works like this: When an “open-end” bond fund starts losing money, investors begin to sell it. Fund managers first use all available cash to pay investors. When the cash is gone, they sell the most liquid securities that haven’t lost much money yet, such as Treasuries. When they’re gone, they sell the most liquid corporate paper. As they go down the line, they sell bonds that have already lost a lot of value. By now the smart money is betting against the fund, having figured out what’s happening. They’re shorting the very bonds these folks are trying to sell.

The longer this goes on, the more money investors lose and the more spooked they get. It turns into a run. And people who still have that fund in their retirement account are getting cleaned out.

Bond funds can be treacherous – especially if they hold dubious paper, which is never dubious until it suddenly is. And when they get in trouble, you want to be among the first out the door. Here’s one of our more recent warnings on open-end bond funds, May 20 this year: Are These Ticking Time Bombs In Your Portfolio?

The $1.8-trillion or so of US junk bonds are everywhere. Investors loved them because they have discernible yields in the Fed-designed zero-interest-rate environment. Junk bonds were hot, and so were the funds. People went for them, with no idea that they were putting their nest egg in a fund larded with explosives.

A significant part of Corporate America is junk rated, well-known names like Chrysler, Valeant Pharmaceuticals, or iHart Communications, yup, the LBO wunderkind owned by private equity firms and weighed down by $8.9 billion in debt that is now “distressed.”

They issue debt because they’re cash-flow negative and need new money, or because they gorge on M&A, or have to fund share-buybacks and special billion-dollar dividends back to the private equity firms that own them. During the boom years of the credit bubble, nothing could go wrong. And now, as ever more junk bonds wither, crash, default, and cause their owners to tear out their hair – just then, a bond fund implodes.

And the next crisis hasn’t even started yet.

Even we, cynical as we are about the credit bubble, its demise, and what it means for bonds and bond funds, didn’t expect it to happen this soon. This is how the Wall Street Journal introduced the topic:

A firm founded by legendary vulture investor Martin Whitman is barring investor withdrawals while it liquidates its high-yield bond fund, an unusual move that highlights the severity of the monthslong junk-bond plunge that has swept Wall Street.

The fund is Focused Credit Fund by Third Avenue, which manages other funds and has $8 billion in assets under management. Earlier this year, the fund had about $2.5 billion in assets. Then its asset values plunged – the fund is down 27% this year – and redemptions hit, whittling it down to $788 million.

It wasn’t the only high-yield bond fund to lose money this year – the 30 largest ones tracked by Morningstar have lost money – but it’s one of the worst.

To stop the forced selling in an illiquid market, while hedge funds had figured out what was going on and were shorting the bonds and driving down prices even further, and to put all the remaining investors into the same boat, the company decided to stop filling sell orders.

The Wall Street Journal:

The firm took the unprecedented step, notifying the SEC just hours before publicly announcing the transaction, because it needed to act quickly to preserve its remaining assets, said Third Avenue Chief Executive David Barse. Obtaining “relief from the SEC is a time-consuming process, and time was not on our side,” he said.

So they’ll lock up everyone’s money for the time being, what’s left of it, put the remaining assets into a liquidating trust, and sell them off gradually, rather than at fire-sale prices, and eventually liquidate the fund.

Investors will get some of their money back on December 16. The liquidation process may take more than a year. Investors better be ready for a long wait. Even then, they’ll eat big losses. That’s the rosy scenario. It assumes junk bonds don’t go downhill from here.

But those first out the door were made whole. That’s how open-end bond funds work when things turn sour. On the other hand, investors who own bonds outright can hold them to maturity. They lose money only if the bond defaults.

What’s next? The Wall Street Journal:

Now, investors are focused on whether other funds may run into similar investor withdrawals and problems as the year-end approaches. Many investors move to exit losing funds and investments late in the year to generate losses to reduce capital gains taxes, traders said.

Then there’s the lesson that might motivate investors: first out the door wins. They’re already heading for the door.

$3.5 billion in retail cash fled US junk-bond funds during the week ended December 9, S&P Capital IQ LDC reported on Thursday: $2.8 billion of mutual-fund outflows and $637 million of ETF outflows. It was the second largest one-week redemption ever, behind the record $7.1 billion outflow during the week ended August 6, 2014.

“We are looking at real carnage in the junk bond market,” bond guru Jeffrey Gundlach announced in a webcast on Tuesday, as the high-yield market takes on ominous tones and threatens not only the broader economy but also stocks. Read… Bond King Gets Antsy as Junk Bonds, Which Lead Stocks, Spiral to Heck

Enjoy reading WOLF STREET and want to support it? Using ad blockers – I totally get why – but want to support the site? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.