The costs of dodging negative interest rates.
By Nick Corbishley, for WOLF STREET:
In the event of a market shock, 40% of European funds focused on junk-rated bonds — ironically named “high-yield” funds — would not have enough liquid assets on hand to meet investor withdrawals, even if the withdrawals in one week amount to only 10% of the fund’s net asset value, the European Securities and Markets Authority (ESMA) warned this week, raising yet more concerns about the risks associated with the liquidity mismatch at funds that offer daily redemptions while holding illiquid assets that can take much longer to sell at survivable prices.
In the wake of liquidity problems at H2O Asset Management and the recently gated £3.7 billion Woodford Equity Income Fund, two UK-based firms that remain under ESMA authority until (or unless) the UK leaves the European Union, central banks and financial regulators have issued a string of warnings about the liquidity risks posed by open-ended funds.
Bank of England governor Mark Carney caused consternation in the fund industry by saying that open-ended funds like Woodford’s are “built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid.” They could even pose a systemic risk, the Bank of England warned in July. Similar concerns have been raised in recent weeks by the European Systemic Risk Board, the Bank for International Settlements, the International Monetary Fund and the G20’s Financial Stability Board.
Now, it’s the turn of Europe’s top securities regulator to sound the alarm. As part of what it calls a “pure redemption shock simulation,” the regulator examined roughly 6,600 bond funds that were set up under UCITS (Undertakings for the Collective Investment in Transferable Securities), the EU regulatory framework for mutual funds. These UCITS funds had an aggregate net asset value (NAV) of €2.5 trillion. ESMA wanted to determine how these funds would cope if investors demanded redemptions worth the equivalent of 10% of a fund’s value in a week.
What ESMA found was that while the majority of funds would have sufficient liquid assets on hand to meet investors’ redemption requests, there were “pockets of vulnerabilities,” especially among “high-yield” (HY) bond funds and emerging-market (EM) bond funds.
“In particular, UCITS offering daily redemptions to investors while investing in less liquid assets such as HY or EM bonds might be subject to a liquidity mismatch,” the authors note. “HY and EM fund flows tend to be more volatile than other fund styles,” having experienced large outflows during the global financial crisis, as well as during the taper tantrum in mid-2013.
In ESMA’s redemption shock simulation, up to 40% of HY bond funds could experience “a liquidity shortfall”, meaning that their holdings of liquid assets alone would not suffice to cover the redemptions. Even after burning through their cash holdings, portfolio managers would still need to offload around €12 billion of assets to meet the redemption orders. And those assets, consisting largely of bonds of junk-rated companies, are not so easy to sell at survivable prices, especially in the midst of a broad market sell-off.
In a market whose average daily trading volume is around €7 billion, the inevitable outcome would be downward pressure on the prices of high-yield bonds. That, in turn, could lead to a downward spiral as prices are pulled even lower, sparking a second round of selling. In such a scenario, high-yield bond funds could lose around 11% of their value, ESMA warned. Given the growing size and importance of Europe’s fund sector, that could be enough to generate all kinds of mayhem and contagion, or as ESMA puts it, “material second round effects”.
“The resilience of the fund sector is of growing importance as it accounts for an increasing part of the EU’s financial system,” said Steven Maijoor, chairman of Esma. “Therefore, it is crucial to ensure that the fund industry is resilient and is able to absorb economic shocks”.
Between 2007 and 2018 the total net assets managed by EU-domiciled UCITS funds have increased sharply, from €6.2 trillion to €9.3 trillion. Europe’s fixed income fund industry has more than tripled in size, from around €775 billion to €2.6 trillion. HY and EM bond funds account for a relatively small part of that universe but they are growing fast as the desperate hunt for yield intensifies against a growing backdrop of negative interest rates. Between 2007 and late 2018, the proportion of HY and EM bonds funds grew from 5% to 8% and from 4% to 9% respectively.
ESMA’s proposed solution to the liquidity challenges facing many high-yield bond funds is to require that all asset managers across Europe carry out quarterly liquidity stress tests on their funds from the end of September 2020. This has provoked a chorus of complaints from fund managers about the extra costs they will have to bear, as the stress tests will require new computer systems to be developed. There are also concerns about the scarcity of reliable market data.
There is no mention in ESMA’s report of the role of the ECB’s negative interest rate policy, which is making it more and more difficult for investors in Europe to find positive-yielding, investment-grade assets to invest in. The inevitable result is that more and more of these yield-starved investors end-up chasing the positive, albeit shrinking yields, offered by much riskier fixed-income assets such as emerging market bonds or junk-rated corporate bonds.
That would be OK too. But many of them, rather than doing the chasing themselves, are handing their money to high-yield bond funds or emerging market bond funds to do the chasing for them. But if recent events in the UK are any indication and as financial regulators and central banks are increasingly warning, many of these open-ended funds are much riskier than their prospectuses seem to suggest — with the ultimate risk being a run-on-the-fund.
During times of market stress, a run-on-the-fund, and the forced selling at fire-sale prices that would ensue, could wipe out a large part of the principal investment even if the underlying bonds don’t default. And if fund managers block redemptions to keep the fund from collapsing, as has been the case in the UK, investors in these funds suddenly find themselves unable to access whatever remains of their money. By Nick Corbishley, for WOLF STREET.