Wolf Richter wolfstreet.com, www.amazon.com/author/wolfrichter
“Liquidity issues at bond mutual funds could result in wider contagion and affect other parts of the financial system and the macro economy.”
Bond investors go for different risks and returns. There is buy-low-sell-high, unless things don’t work out and it’s buy-high-sell-low. Buy-and-holders buy bonds when issued and hold till maturity, collecting coupon payments and then getting their money back – unless things don’t work out.
Other investors buy a bond when a company or an entire sector gets in trouble, such as the shale-oil space in 2015 and 2016. They might buy a distressed junk bond for 40 cents on the dollar, at a yield of 20%, that then does not blow up, allowing them to collect coupon payment representing a 20% yield from cost, year-after-year until maturity, when the bond is redeemed at face value for a capital gain of 150% (cost 40 cents on the dollar, redeemed at 100 cents). Sweet deals, if it works out.
There are many ways of taking calculated risks with bonds. And that is cool.
What is not cool is when you invest in a conservative sounding open-end bond mutual fund that holds mostly corporate bonds, and it experiences a “run on the fund” and blows up and takes a large part of your principal down with it — making it far riskier than the actual bonds it holds. This happened to a number of open-end bond mutual funds during the Financial Crisis, including Schwab’s family of “YieldPlus” funds.
Investors never knew of those risks and were never paid to take those risks. They thought it was a low-risk investment. Instead it was an open-end mutual fund that experienced a run-on-the-fund and collapsed.
I’ve been lambasting open-end bond mutual funds for years, including when the Focused Credit Fund by Third Avenue experienced a run-on-the-fund in late 2015 and was ultimately liquidated. There are two fundamental dynamics at work:
“Liquidity mismatch”: The risk from open-end bond mutual funds when they mostly hold corporate bonds, mortgage-backed securities, and the like, comes from a structural problem: investors can sell the shares of those funds on a daily basis; but the underlying assets such as corporate bonds, including junk-rated bonds, are not liquid and can take days to sell at reasonable prices, even in a good market. This is the liquidity mismatch.
“First-mover advantage”: When redemptions requests are piling up as investors are trying to get out the door, the bond fund will meet the first redemptions by using up its cash balance. Then it will sell the liquid Treasury securities it has for this purpose. Then it will sell the most liquid corporate bonds. All along net asset value (NAV) will remain stable, and the first investors out the door will be fine. This is the infamous “first mover advantage” at open-end bond mutual funds.
The remaining investors are then stuck with the most illiquid bonds, and also with the higher trading costs incurred during the prior asset sales but not yet fully accounted for. When the fund has to dump the remaining illiquid bonds at cents on the dollar to some hedge fund, the NAV suddenly plunges and panic breaks out among the remaining investors in the fund, and they all try to stampede through the narrow door.
I was just focused on individual investors. But there is a broader problem.
Fitch warns these bond funds could trigger a financial crisis.
If enough open-end bond mutual funds experience runs-on-the-fund simultaneously, and collapse together, investor fears could spread to other funds. Wide-spread forced selling would set in as bond prices crash, freezing up credit markets and possibly triggering a financial crisis.
The risk of a widespread contagion-driven bond mutual fund meltdown triggering a financial crisis is not huge. But it’s apparently big enough for Fitchto warn in a new report — “The Coming Storm: Bond Funds’ Potential Impacts on Financial Stability” (behind paywall, here’s a summary) — that open-end bond funds are “a potential source of financial instability.”
This has always been the issue, but now the setup is bigger and riskier than it was during the Financial Crisis, as according to Fitch, “global QE, prolonged low yields, technology, and a wave of regulation” have contributed to the surge in open-end mutual funds and exchange-traded funds (ETFs).
“These market dynamics increase the number of unknowns in the financial markets, even if the underlying fund assets are still performing, especially since weaker liquidity can contribute to valuation volatility,” Fitch says.
“Interconnectedness among funds, non-bank financial institutions (NBFIs), banks, and the rest of the financial market adds to the complexity of understanding whether this could be severe enough to affect financial stability.”
Here are some of the specific risks Fitch points out
“Gating,” designed to stop a run-on-the-fund, might ironically trigger more financial instability:
“High redemption activity could test relatively newly implemented extraordinary liquidity management tools, such as suspending redemptions or ‘gating.’ These tools have helped to contain open-end fund stress to individual funds or fund sub-sectors in the past, but there is a risk that gating could spark contagion in other funds as it could be disruptive to market confidence. Changes in market dynamics or a combination of idiosyncratic and macro stresses could increase the spillover effects.”
Leveraged bond funds – especially with derivatives being used to create higher effective leverage – “are more likely to be forced to deleverage as a result of margin calls in a market downturn, with potential for adverse spillover effects, including for its counterparties.”
Ironically, “dry powder” adds risk. “Dry powder” – private equity firms’ “uncalled investment capital” – across the industry has risen to toward $2 trillion in January 2019, according to Fitch, which cited Preqin data. This is money that specialized funds want to deploy at times of severe financial market stress, to buy assets for cents on the dollar. This would help provide liquidity and ease pressure on market prices. But, Fitch says, there are financial stability implications because that “dry powder” doesn’t actually just sit there waiting; something – namely open-end mutual funds – has to be sold to get that “dry powder”:
“As alternative investment managers call committed capital from their limited partners (LPs), these investors are likely to need to switch from other investments, at least partially open-end funds, to raise cash to meet the calls. LPs’ abilities to meet capital calls could be more challenged in a market stress. A large shift of LP capital away from mutual funds to alternative investment funds during a crisis could also contribute to forced sale risks at open-end funds.”
90% of bond funds lack a primary defense against a run-on-the-fund. Regulations allow funds to impose terms on redemptions to where they’re more in line with the liquidity of the underlying assets, such as slower redemptions, rather than allowing daily liquidity. But in Fitch’s sample of 1,832 US credit funds, 90% offered daily liquidity – which makes them sensitive to a run-on-the-fund.
Trying to hoard cash is good, until it isn’t. Bond mutual fund managers, particularly those of less liquid bond funds, tend to hoard cash to soften the liquidity issues, Fitch says, citing a working paper based on global bond mutual fund data by the Bank for International Settlements. Alas, this would “amplify forced asset sales and the post-redemption NAV decline as the manager would sell underlying assets to boost cash buffers in anticipation of redemptions.”
Contagion is real. When Third Avenue’s bond fund collapsed in late 2015, it was just a small-ish fund and it didn’t trigger cascading runs. However, the market did react, Fitch says: “Bonds of higher-quality liquid issuers traded down a percentage point or two, whereas lower quality, less-liquid names dropped three to five points….” It also triggered a 16% outflow from junk-bond mutual funds over the three-month period, indicating that the collapse of just one small-ish fund caused stress in the sector.
The known unknown risks created by QE. “The ‘known unknown’ is what combination of problems in terms of credit and market conditions could cause runs in multiple structurally vulnerable credit funds, where extraordinary liquidity measures by fund managers would not be sufficient to contain the problems,” Fitch explains.
“While previous periods of micro-level stress in the bond fund universe did not threaten financial stability, the rapid growth in open-end credit funds and the significant distortions to credit markets caused by QE mean that market conditions look very different now.”
“Liquidity issues at mutual funds could result in wider contagion and affect other parts of the financial system and the macro economy, especially as mutual fund holdings of US corporate bonds increased significantly since the last crisis….”
For the Fed, getting rid of MBS faster and shifting to short-term Treasury bills will be on the list. Read... Fed’s QE Unwind Reaches $434 Billion, Remains on “Autopilot”