“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 Fitch to 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; it’s invested in something – often open-end mutual funds because of their convenience – that 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, and the CCC-and below rated average yield jumped to over 20%, indicating that the collapse of just one small-ish fund caused additional 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”
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If there is another financial crisis, similar to 2008, in the next year or two, this risk from open-ended bond funds could be highly significant.
Cautious investors probably feel quite safe from Stock Market fluctuations and volatility putting a percentage of their portfolio into short term fixed interest funds. But, as this article points out, this seemingly ‘safe’ investment strategy may in itself be risky unless you are quick enough to be ‘the first one out the door’.
Every selling frenzy begins with a flashpoint, or catalyst. After a brief period of perma-bull buy-the-dip denial (bonds or stocks), numbness sets in as speculators (no such thing as investors anymore) cling to hope, followed by despair, then desperation, then sheer panic, then apocalyptic loss realization. There will be no coming back from the next crash, no QE, bailouts, cash for clunkers, Bernanke-Paulson-Geitner mercy meetings – nothing. Just scorched amazement at how obvious the problem was all along and that we (central bankers, governments, greedy speculators) let it happen. Trading curbs will only exacerbate the sell-off and unending surges downward. In its penultimate aftermath, a total restart will be in order and fiat currency itself will be regarded as folly. Total global debt of nearly $300T has to be write down. So what will be the flashpoint? My top 3, which may happen concurrently:
Housing collapse, globally
China credit collapse
EU collapse and credit defaults
There will be no escape from the pain for any of us if the fiat system collapses, but the pain will be relative.
Those of us who “live on the land”, isolated to some extent by distance from densely populated ares while making some use of the land’s genuine productive capacity for food and fuel, and maintain some level of transcendent liquidity with junk silver, may fare better.
Meanwhile, we are fools, watching the “real world” of opportunity go by.
No QE? No bailouts? Come on, man are you serious? What’s more politically palatable; 125 million guys out of work or free money for all? Of COURSE there’s gonna be bailouts. You heard the Bernank- “I’ll throw money out of helicopters” and why not? The people demand it.
Also, unlike the ECB the Fed has a DUAL mandate and so targets full employment. It has to act when people lose jobs
Pension funds too?
The entire worldwide financial system is already in collapse mode much, much worse than anything seen back in 2008.
There is no way to deleverage, there is no such thing as liquidity (ie something that has to be mopped up – if you recall that discussion) finance is not water, its electricity, it flows or it doesn’t, the existing volume of bonds is as good as money. As long as supply exceeds demand the stock market will never “unwind” its gains. The problem is volatility because the sheer volume of money has created deflation, money loses value, and there is no way of shrinking the supply, so we will veer between deflation and hyperinflation once more.
Haha that’s what I did few months back. But my 401k doesn’t have a cash option and they told me this is closest alternative. Any tips?
Haha Wolf knows what he’s talking about!
Hint… JNK and HYG
I been scoping both daily since December, HYG and JNK have a seriousss play being made on them, I remember there was an article saying there was inflow of 1.2 billion in January for Junk ETF’s, all while behind the scenes some institutions were furiously buying PUTs same time as buying shares. One day alone there was over 250,000 PUTs bought for March 19!!! Now is it gonna crash by march 19, likely yes but not 100 %… But the run definitely starts next week when 31 Billion QT happens on the 20th, every single buyer except liquidity providers of Junk ETF’s in Jan were buying same amount of PUTs at same time… Do the Math
Wolf, some people are gonna make a fortune with this recession! Wait until US Shale earnings start next week, JNK is 83 Industrial, HYG is 85 %
Thanks. Learned this a few decades ago, that bond funds aren’t bonds!
Are you seeing what I’m seeing?
“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)”
And:
“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….”
Sounds like a perfect reason for the Fed to cut interest rates, tell us a “normal” balance sheet is MUCH higher than recently previously though, and launch a much bigger and better QE. Maybe they can call it “Operation Reverse MBS Un-Twist” so it’s cool or something.
Let’s see how Powell reacts if Mr Market does another 10% hissy fit. I expect Powell Capitulation Act II as he once again grovels before his masters.
I think Powell grovels before his masters because the volume of money out there on the books of the 25 biggest financial institutions is way bigger than the GNP of the USA (it’s actually probably bigger, if you count the derivatives, than the GDP of the planet). At one point the Royal Bank of Scotland had 6 trillion pounds on its books. In other words, it was worth more than the annual production of goods and services in the entire UK at the time. Institutions like that have immense power. And yet we look at manufacturing or retail or real estate and imagine that they are the “real” economy. It’s like comparing a person who owns an 1100 acre farm with a nice house, a big barn, and some substantial outbuildings to a person who lives on a three acre estate and assume the person with the farm must be richer or more important because he has more physical assets. If the person in the house is a hedge fund manager worth 2 billion who manages 90 billion, his power and influence dwarfs those of the farmer (yes, I know, when Armageddon comes the farmer is better off–but it ain’t happened yet).
When will they learn!
You may as well just buy an ETF that tracks a bond fund.
Then buy insurance against it losing value.
Then some insurance against that insurance being invoked.
“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.”
Given that junk bonds seem to have a life of its own and seem oblivious to underlying risks, one can only wonder at the rot under the surface of the financial system and how well the central bankers (the Fed, PBOC, BOJ and ECB) are sleeping at night. After all, if the risks manifest itself then it is going to take some liquidity to stop the crisis (ironically creating a bigger crisis down the line due to “The known unknown risks created by QE”).
Effect of Greenspan’s put is showing itself after 30 years.
There was an old lady who swallowed a fly…
Bond funds are a mine field in a rising interest environment and not just because of liquidity issues. I won’t touch them. I buy and hold a mix of bills, notes and double tax free GO municipals for the bond portion of my portfolio. Not complicated and fully under my control.
Wolf, thanks for this article, very eye-opening. This article seems to highlight the risks of open-ended corporate bond funds. Are there similar “run-on-the-fund” collapse risks with open-ended treasury funds or municipal bond funds? If so, what would trigger them?
The US Treasury market is huge ($15 trillion) and very liquid, and the securities are very similar, unlike corporate bonds. So it’s easy to find buyers. And the Fed backs them in case something bad happens. So it’s very unlikely that a Treasury bond fund — if it is truly limited to Treasuries — will experience a run. I would not be worried about.
Muni bond funds are not on the same level as Treasury bond funds. Also, during the next downturn, there may be some larger municipalities defaulting. That could cause a scare. They’re not backed by the Fed. So a run is possible, though not likely.
GO Munis in most states should be just fine because they are backed with taxing power of the local government. However Revenue issues are varied and some will have trouble while others will not. Depends on the entity financed.
Yes, but in reality a big funding pool also signifies that a loss of faith in the treasury market, which would be equivalent to loss of faith in the currency or national outlook, would be “dramatic”. The size of that funding pool however does mean that there is more leeway for compensation in values should the whole feel threatened or become stressed at a certain point. This is all really part of the paradigm of financial limits, debt, globalism, and so forth, as well as how societies react to them along with their political representatives. Historically the worst REAL rate of return on US government bonds is listed by investopedia as a negative 19% in 1918, and I assume by looking at other charts this was due do inflation, though am not sure. So the nightmare scenario is maybe something like monetary/price inflation via QE or other reducing real earnings to strong negative on treasuries – they cannot realistically be pumping money into the economy while demanding high yields (you read that right) to empty it and slow inflation, yet pump money in they would have to to keep the liquidity in the system to stop a total financial and economic and societal meltdown. It is maybe a thinner line to walk than we imagine, but other more stable asset classes within the monetary and financial system are hard to find, limited to other currency, precious metals and other portable or practical commodities maybe.
So yes, treasury bond funds have the potential for a run, you would likely get redeemed as that market is vital to fed policy and national stability, and it is possible that real losses would result for investors even though they were nominally redeemed. In reality though people will normally want to be more concerned at the evolution of their country first before ever considering choosing another safer asset to treasuries.
Prepers and goldbugs obviously have their own opinion on that though.
I’m thinking that if all the bond funds and stock market
funds crashed at the same time there is still enough
money and credit to manage it all.But if the derivative market
froze then all bets are off .In that case hopefully you
have a good friend who owns a working farm .
There are plenty of ways to hedge your position, you own the bond ETF, you buy the equivalent yield ETF. The put option market is not really a free market, since they went to Black Scholes, the underwriters accept the volume and layoff the position on one of the other ETFs probably. Or they write a bunch of derivatives. In theory the system is fine, as long as you can take either side in the trade.
Didn’t the last crisis demonstrate that just because you have a passel of counterparties doesn’t mean that they have the liquidity to meet their obligations if things go wrong?
Its not liquidity its collateral. http://www.lbma.org.uk/assets/Alchemist/Alchemist_92/Alch92Silva.pdf
Ding Ding Ding James,
You are the winner. If the counterparties have their liquidity dry up, the sausage machine will seize up. This is a good article on the mutual bond funds but if / when they choke, some of the problem spills into the equity markets as well and ETFs are a much bigger chunk of the equity market these days and the ETFs trade interday. Do equity ETFs actually trade their holdings interday or does it just look that way to their retail customers and do they do some type of wholesale true up at the end of each trading day with their institutional partners?
Hi Ambrose,
I would appreciate it if you would explain the idea that you write about-“you own the bond ETF, you buy the equivalent yield ETF”. It sounds interesting.
If you are long the ten year, you can also buy the DTYS which is the bear ETN. Institutions write their own derivatives. There is no reason to get caught on the wrong side of a trade, so money will never disappear, which is a blessing and a curse. The real enemy is volatility.
Short duration bond funds should do just fine. Only the long duration with lower credits might have a problem.
Short duration being less than say 2?
I would say 2 yrs duration should be safe … but, if and only if the fund is not heavy into security financing. In a crisis, rolling financing trades forward can be a problem and that can strain the fund’s cash.
When the bond market tanks poor and middle-class taxpayers will bail it out, one way or another, and probably both.
Just like last time, and the time before that. And so forth. And if it doesn’t tank they’ll still bail it out, just to make sure.
Market distortions are features, not bugs, so it’s not a problem. This is how the rich get richer, and the obscenely rich know they’ll get richer no matter what happens and therefore can go all in, distortions and all.
“When the bond market tanks poor and middle-class taxpayers will bail it out, one way or another, and probably both. ”
From what I read, it looks like the middle class is already poor and the poor have nothing. Have you seen the charts of household debt and student loan debt?
Maybe there is more room for the middle class to carry more responsibilities but there has to be a limit. Statements suggesting that the middle class can just do another bail out to me is like Marie Antoinette suggesting that if there was no bread, then the poor should just eat cake..
You’re catching on.
Are there no prisons? Are there no workhouses? Don’t these people have an extra kidney they could sell, or surplus offspring?
I had an acquaintance who was for a time the Country Managing Partner for a global I-Bank. He was well along the spectrum for risk appetite.
In the GFC, he personally took a huge haircut, telling me “I’m done with stocks … it’s only bonds for me now on”.
Looks like he might soon go from short back and sides to a shaved noggin.
This “liquidity squeeze” issue affects certain classes of hedge funds, which like bond funds tend to concentrate investments in securities that aren’t sufficiently liquid. A lot of evidence says that the December selloff was exacerbated by a Liquidity squeeze at hedge funds facing redemptions. The hedge fund $$ were clustered in narrow sectors of the market. The banks undoubtedly knew the positioning of the hedgies and were happy to help squeeze them in the name of their own self-preservation.
For individual investors, it can be better to own individual bonds or CDs than bond funds. But you have to choose the bonds wisely and do some due diligence. Treasuries and brokered CDs are pretty simple and munis can be managed with effort, but corporate bonds are a swamp.
Many 401Ks don’t allow ownership of anything other than mutual funds. In that case safest bet is a treasury fund. Definitely avoid the funds that carry the toxic waste that Wolf writes about! Treasuries are what everyone flees to when the going gets rough, and are readily exchanged for cash thanks to the Fed’s discount window providing a guaranteed buyer of last resort. I’m pretty sure Treasury funds have never had any of these issues that Wolf is talking about.
Bond index funds should theoretically be safer from the run on the fund especially if they have a good chunk of government bonds. In the run for safety, government bonds will be the last refuge.
Wolf first time commenter and long tern reader. Do you believe the risks in muni bond funds are risky as well?
Matt,
At about the same time you posted your question, I replied to “ifly” further up, with my opinion on Treasury and muni bond funds. So our comments crossed in the mail, so to speak. Have a look.
A lot of people seem to think it’s somehow “safer” or that they will be better positioned by living in a rural setting where they can grow their own when “the collapse” finally arrives. Better have the means to hire an army because the hungry hordes will be coming for you and your crops. Better to be in a city where there will at least be a thriving black market for necessities.
MartinSF,
I think you assume to much and know to little. Living to close to a major metro area may have its issues but IF it ever got to hoards, most of the fuel would be gone and the roads would be cluttered with broken and abandoned vehicles. Few city people will walk 100 or 200 miles thru unknown territory to get an unknown amount of possible food that will be protected by people who know how to use guns. Maybe if you went without weapons and with a willingness to work hard for little, maybe they’d take you in.
As for growing your own? That’s another problem. How do you do that with out water and for most, water means electricity, which if it ever got to hoards, electricity would not be free flowing. Not to mention that most of the seeds are hi bred and not heritage. Or that the skills of sustainable farming are mostly lost.
We better all hope and pray that things never get bad enough that the hoards are hungry.
So this is how the Corporate Junk Debt Bubble ends. Not with a steady series of defaults of individual companies stretched out over years, but with a Big Bust, and probably another financial collapse, as almost all giant unsustainable debt bombs do.
Nearly $9 trillion worth only a third of which are high grade bonds, the rest BBB junk
1. So is it reasonable to try and buy individual bonds to mimic the behavior of bond funds.
2. So is it possible to track the bond funds to see how much redemption activity is taking place to get some forewarning. Is this going to be an overnight thing like Lehmans or be over some months
Though this by itself won’t bring the house down, this fragile piece can’t hold up when averything else falls apart. This does look like a good Black Swan candidate though, the spark hat lights the fuse.
Wolf, thanks for drawing attention to this. I’ve thought that the open-ended fund ETF structure had some major, major systemic risks baked in for about two years now, but never bothered looking into it.
The question is – what are the potential catalysts for a “run on the fund” or massive redemptions? This was the part that I could never think of an answer – rising consumer, mortgage, or auto credits?
I guess my point is that I see it more as the second or third domino to fall, rather than the direct exposure that causes more dominoes to fall.
But what are your thoughts on those catalysts?