“Just imagine that a bond is a slice of cake, and you didn’t bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that … If you pass around enough slices of cake, then pretty soon you have enough crumbs to make a gigantic cake.” – Tom Wolfe, Bonfire of the Vanities
In January of this year, the US Securities and Exchange Commission quietly issued new guidance for risk management in fixed income. As the guidance noted, after nearly three decades of bond market growth, the net assets of bond mutual funds and exchange-traded funds are at historic highs of $3.6tn, with much of this growth coming recently – bond fund and ETF assets have increased by over $2tn since the end of 2008.
At the same time, the role of large dealer-banks in the market has sharply reduced thanks to a variety of factors — think new regulation such as the Volcker Rule and a general new-found love of post-crisis risk management. When big bond funds eventually look to sell, the concern is that there will be no one else to take the other side of a crowded trade.
On that note, the FT reported last week that Federal Reserve officials have discussed whether regulators should impose exit fees on bond funds to avert a potential run by investors. As Jeremy Stein, former Fed governor, noted in the article, there is a fundamental tension between “giving people a liquid claim on illiquid assets,” which is what bond mutual funds and ETFs are increasingly doing now thanks to market structure changes.
This, unsurprisingly, promoted a whole lot of discussion amongst market participants.
Here, for instance, are Credit Suisse analysts led by Ira Jersey on the FT story:
Press sources raised eyebrows (and prompted some ire) early last week by suggesting that the Federal Reserve was considering gates or redemption fees on bond mutual funds. We had presumed any such discussions would be due to their Dodd-Frank financial stability mandate through the auspices of the Financial Stability Overnight Council (FSOC). However, when asked about this at the post FOMC meeting press conference, Chair Yellen made clear that she was not aware of any such proposals and that the SEC, not the Fed, regulated mutual funds. Therefore, the story seems to have been either incorrect in the attribution of the source (i.e., confused the SEC and the Fed), perhaps the reporter spoke with others at the Fed staff who have discussed it, or any number of other possibilities. Regardless, the fact that Chair Yellen did not know of any discussions and did not mention that it was a topic at an FSOC meeting suggest any proposal out of the SEC is quite far off, if it will ever happen.
Now, everyone occassionally makes mistakes but it would be a doozy to confuse the SEC with the Fed. In fact, as the story noted rather prominently; “Introducing exit fees would require a rule change by the Securities and Exchange Commission, which some commissioners would be expected to resist, according to others familiar with the matter.”
Instead the fact that discussions were held merely underscores the extent to which liquidity issues in the bond market have become a financial stability concern. Investors talk about it. Banks talk about it. And so, regulators talk about it.
And yet there seems a decided dearth of options to improve the market. Single-dealer bond trading platforms have failed. Bonds come in a variety of Cusips, making them difficult to trade electronically in general. Even without new regulation, it’s unclear whether dealer-banks would want to step in during heavy one-way selling because, despite what many people think of the big banks, these people generally aren’t idiots. That leaves exit fees, which are a decidedly unpalatable option for regulators, or it leaves a set of much softer efforts to prep the market for potential withdrawals.
In its guidance, the SEC talked of better risk management and better shareholder disclosures, which is really the equivalent of bringing a knife to a gunfight. The watchdog’s most salient recommendation (which isn’t saying much) was a suggestion that bond fund managers stress test their portfolios and think about alternative sources of liquidity — “such as cash holdings and other assets that would not require selling into declining or dislocated markets if volatility or market stress increases.”
And on the cash point, here are the Credit Suisse analysts again:
Mutual funds hold cash for a variety of reasons, but first and foremost they hold cash in order to meet shareholder redemptions without having to sell assets. Should funds want to be underweight duration but either unwilling or unable to short securities or derivatives due to mandates, they would hold more cash assets to reduce duration. However, performance and cash holdings do not always correlate. One reason is that many funds hold significant amounts of cash but use overlays to increase duration.
Some funds utilize Treasury and Eurodollar futures and over-the-counter derivatives such as the CDX or interest rate swaps in order to add back risk that would otherwise be underweight in their portfolio due to the cash holdings. Depending on the fund, there may or may not be specific restrictions as to how much cash/short-term investments funds hold. Each fund’s investment mandates (found in the prospectus) are different so it is difficult to generalize except to say that “Strategic Income,” “Total Return,” and similarly named strategies tend to have the broadest mandates to use derivatives and hold significant cash. Some funds also have minimum holding periods or require investors to pay exit fees; some even have investors pay this upfront, providing a refund it if they hold the fund for a particular period.
This is important because funds that can use derivatives can perform the overlay strategy noted above, and allows them to hold more cash even if they happen to be market weight, or even overweight, duration.
Finally, we should note that funds have the ability to finance a portion of their portfolios via the repo market to raise cash without having to sell assets. Although this might be difficult to use this product if a fund receives a large number of redemption orders late in the day that go well beyond their cash balance. That said, some funds have the ability to delay withdrawals under certain circumstances and could pay shareholders in securities instead of cash. Presumably funds would not want to utilize any of these extraordinary measures unless they had no other alternative – which, given cash balances, seems unlikely on a systemic basis. That being said, the dispersion of relative cash holdings means that there may be a smaller fund with below average cash that would face difficulty in the event of a large wave of redemptions.
Indeed there might be. (As a side note, isn’t it fun that large bond funds are using futures and derivatives to boost their returns while maintaining a cash buffer in the event of redemptions? There is absolutely zero chance that selling risk and/or volatility will blow up at the same time that those cash holdings are really needed [-- Sarcasm? Ed])
The point we are getting at is that there is a potential lag, or variation, between the preparations of bond fund managers and the vast changes that have occurred in bond market structure. Responses to those changes are so far being made on the margins — more cash buffers, more disclosures, some experiments with new electronic bond trading platforms — while pretty much nothing is being done to address the fundamental causes of the lack of market liquidity.
Call it liquidity leverage – FT Alphaville
If everyone is a mini-LTCM that’s fine, right? – FT Alphaville
A by no means extensive list of FT.com articles on bond market liquidity – FT.com