Contagion from Liquidity Crunch at Junk-Bond Funds to Trigger “Material Second Round Effects”: EU Securities Regulator

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.

Hedge funds have field day front-running the liquidation while 300,000 investors are left twisting in the wind. Read… Woodford’s Shuttered Fund Crushed Further by Plunging Stocks in its Holdings, such as Muddy-Waters Target Burford Capital

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  31 comments for “Contagion from Liquidity Crunch at Junk-Bond Funds to Trigger “Material Second Round Effects”: EU Securities Regulator

  1. I think its possible (with a few ETFs anyway) to make any investment illiquid in a crisis. I want to say forget it, own what you believe in. I like junk bonds because they have a source of revenue to pay the interest, which (US) government does not have any longer. In my pecking order Europe’s currency is preferable to US assets, and stocks to bonds, and Corporates to Treasuries, by extension. What’s the opposite of a bubble? When everyone puts their money in zero yielding fixed income. The author of the Big Short thinks Fixed Income is a bubble. That’s a poor choice of terms. Is it a bubble when everyone buries cash in their backyard? You don’t need an ETF for that.

    • 2banana says:

      Do your “investments” rely on a greater fool for you to make money?

      Guess how that ends…

    • Sunny129 says:

      ETF of any kind can be sold ‘during mkt hours’ for loss/gain, but Mutual Fund of ANY kind has to be liquidated at it’s NAV after the close of the mkt hours!

      which one would you prefer be holding on any kind of ASSET, assuming one is IN the mkt? MFund vs ETF?

      Except for a few low exp MFunds, most of of my (diversified) assets are in ETFs of various kind in an UNCORRELATED portfolio from +1 thru -1 including bear ETfs/MFunds with nearly 50%+ in cash, since I am in retirement. been in the mkt since ’82!

      ETFs are no panacea but better than MFunds in a BEAR mkt like 2008! Seen it, Been there and done that!

  2. Petunia says:

    A redemption policy for hedge fund assets cannot be uniform because the assets in these funds are not uniform. Each class of assets has its own liquidity profile. Depending on the classes of assets they normally trade or hold, they need to create gates which protect the assets, not the investors.

    These are supposed to be sophisticated investors and need to behave as such, not run for cover at the latest drop. Hedge funds take a long time to unwind in the best of times, in a downturn, it could take years to salvage investor capital.

    • Wolf Richter says:


      Yes, but these are not hedge funds here. These are regular bond mutual funds sold to retail investors, of the type people stick into their retirement accounts.

      • Petunia says:

        Sorry Wolf, it wasn’t clear to me that it was a retail fund. These funds are dangerous as well because investors don’t understand investments classes have a business cycle. Sometimes they go up and sometimes they go down. The expectation that they only get to ride them up is a serious problem. Maybe the gate has to be duration of time the asset is held and where the asset class is in the business cycle. They get to take out more in good times and less in bad times. It’s called risk.

  3. William Smith says:

    It is war; the investors against the central banks. The ONLY sensible thing to do is for investors to just sit on their cash and absorb the small real losses, while avoiding (almost certain) loss of their principal. Eventually when the credit machine locks up, the central banks will realize that the investors will only unlock their funds if risk is priced properly. I know this is a simplistic view, but what other course of action is available when risk is not properly priced? My cash is parked in govt guaranteed savings accounts (in aus) and I am now operating in (depression era) survival mode. I refuse to participate (more than absolutely necessary) in a lunatic financial system.

    • Bucket List Bob says:

      Since 2008 I have invested in nothing.

      I keep a large chunk of change in USD cash and another chunk in physical gold.

      I burn through all income that I generate from various businesses living large, primarily travelling the world.

      There is no point in investing knowing that at some point in the near future your asset is going to zero.

      Some people who are aware of this think I am nuts.

      I will be vindicated when this sh%t show implodes and these suckers are left staring at 0’s across the board.

      That time is not far off.

      • sunny129 says:

        This sh%t show can go on, more than any one would like to imagine! A lot is riding on the 3rd largest ‘everything’ bubble created as a cure after GFC. DEBT levels are unlike any time in human history!

        The Fed/CBers will try to carry on this bubble afloat until it crashes by and on it’s own.

        There are many millions of newbie managers who got in, after the GFC and rode on Fed’s put with S&P zooming over 300%. These guys/gals have never experienced a secular mkt in their life time! For them CBers look omnipotent and they have Pavlovian creatures, since ’09!

        see my comment above about my position. we are in uncharted waters!

      • I think DOW 1,000 will hold but certainly the DOW will drop below the 5,000 level when the U.S. stock market ponzi implodes. I see it today as a long term bear market dating all the way back to the dot-com crash.

  4. 2banana says:

    What could go wrong with the fraud of negative interest rates?

    The best move is not to play this game.

    “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.”

  5. David Hall says:

    The Fed funds rate peaked 1979-1980. Interest rates have fallen for close to 40 years. It would be foolish to think there is no limit to how low interest rates can go.

  6. MC01 says:

    I am speaking out of experience here, but usually high yield bond funds are one of the first things you are offered when you go to the bank and complain whatever you have just been shown has a yield that is not even enough to cover the official rate of inflation.
    The standard pitch for these products is “they are a little bit riskier” but how much riskier? The prospects are extremely incomplete and often vague when it comes to portfolio composition. If I were malicious I’d say the fund managers (and the bank getting a cut by pitching these funds to customers) don’t want us to know what’s inside their funds.

    In late July junk-rated French retailer Groupe Casino entered bankruptcy protection after their debts had soared to €3.3 billion in FY2018 and cost-cutting measures failed to put them under control. Bankruptcy procedures are devastating for shareholders, but bondholders are usually asked to do their bit for the King as well and it’s likely a large haircut will be announced soon.
    A couple weeks later another French junk-rated supermarket giant, Auchan, announced a “restructuring plan” aimed at avoiding a bankruptcy filing after losses started spiralling out of control (€1.1 billion in FY2018 alone). It’s rumored Auchan will attempt a “bond swap” to lenghten maturities and hence pushing paying principals into the future. Not good for junk bond holders.

    Supermarkets have long been big favorite of junk bond funds, partly because their bonds paid tasty coupons and partly because “people need groceries even with Amazon beating retail into a pulp”. Yes, we have Amazon here as well. ;-)
    Turns out people only need so many groceries, that food prices have a nasty habit not to follow CPI and that opening a supermarket every 200 meters will literally destroy profit margins and hence those big tasty bond coupons. This is a sector where junk bond funds will take the proverbial beating as debt restructuring, defaults and outright bankruptcies have started.

    Speaking of defaults, another big favorite of junk bond funds is inching closer to it: Norwegian Air Shuttle (NAS). Tucked among the usual sunshine and lollipops press releases (“passenger revenue edges up”… yes, and losses as well) NAS announced this week that it is in negotiations with bondholders for “more time to pay off bonds”. If it sounds like dangerously close to default that’s because it is.
    I am not a junk bond fund manager, but given NAS has given ample warnings that a default would come over the past three quarters, I would have quietly and steadily reduced my position.
    Oh, and speaking of another big favorite of European junk bond funds, French airline Aigle Azur filed for bankruptcy this week. As the company will likely be liquidated in a matter of months (the routes alone are worth far more than the rest), bondholders will have to take a loss on it, with covlite people likely to only get cents to the euro.
    Despite their well known money woes Aigle Azur was another “cannot do wrong” kind of investment because it was 49% owned by HNA Group of China, which was sure to come riding at the rescue with containers filled with freshly printed yuan. It didn’t happen (as rating agencies rightly predicted) and now quite a few fund managers will have to cover the shortfall or face some very angry people.

    I tremble to think what the ECB has in store for us this week, but I am even more fearful of what will happen once the most clueless person in the crowd will take charge.

    • Unamused says:

      . . . I am even more fearful of what will happen once the most clueless person in the crowd will take charge.


      “The time of the most contemptible man is coming, the man who can no longer despise himself.”

      Thus Spake Zarathustra

    • Petunia says:

      As a woman who worked in tech, a male dominated industry, I have observed that any time the reins of power are willingly turned over to a woman, in any industry, it is a sign that the music is about to stop. There are many examples out there to support my view. While Ms. LaGarde is a very capable woman, I fear that she has only been designated the official bag holder.

      • robt says:

        Lin Su at AMD did a remarkable job of turning things around. Just because a company is in some difficulty doesn’t mean it can’t be revived and flourish. If such a company fails, it may be because it was beyond salvation despite heroic effort, or it may be because the new chief didn’t have the right stuff. In either event someone was given the opportunity to succeed.
        Companies/organizations don’t look for patsies; they look for saviors, the sex doesn’t matter, and the posture of victimhood is not the answer for failure.

      • MC01 says:

        She has been jawboning financial markets by hinting at big rate cuts since her name first cropped up for the job: hardly a heartening indicator of change, even for the worse.
        There’s also her already well-advertised line of “outvoting hawks” which has financial market shills (the kind that suggests you to invest your money in meal delivery outfits and other money-losing ventures) jump up and down with excitment, not an encouraging indicator of radical departure from the past.

        There’s a phrase, variously attributed to Saddam Hussein, Papa Doc Duvalier and Idi Amin Dada: “People often mistake the way I talk for the way I think”.
        I’d like to believe this is such a case, but experience has taught me that if it quacks like a duck, it walks like a duck and looks like a duck the chances it’s anything but a duck are very small indeed.

        • DC Nine says:

          Isn’t that a Ronald Reagan quote?

        • MC01 says:

          I think it’s an orphan quote: it is attributed to many, and may as well have multiple origins, but the exact origins are not known with certainty.

    • fajensen says:

      Speaking of defaults, another big favorite of junk bond funds is inching closer to it: Norwegian Air Shuttle (NAS).

      Yep. A funny thing to observe in “The Market” is that the ‘sort-of doing OK’ SAS (Scandinavian Airlines) seems to be lumped into the same pot as Norwegian by the trade-bots so that “Norwegian News” drives the SAS stock price.

      I think the SAS stock price is about as low as it is going to go, but, what do I know?

      • MC01 says:

        SAS is a curious beast. Apart from 2014 they have been profitable since 2013 but something doesn’t add up, quite literally.
        In FY2018 they carried less passengers than in FY2008 (30 million vs 31 million) and their load factor has been steadily declining since 2013 and it stood at just 75.7% in FY2018.
        Turning a profit with under 80% load factor is very difficult, unless one has very peculiar financial and/or fiscal arrangements in place. Emirates (77% load factor) is possibly the most egregious example of that.

  7. Unamused says:

    This is the natural result of the Financial Industrial Complex getting itself into trouble by assuming it can extract more wealth from the Real Economy than the Real Economy is actually capable of producing. Which is to say, it assumes it can squeeze so many billions out of the Real Economy and places its bets accordingly, and then risks losing its bets when the harvest inevitably falls short.

    To avoid losing its bets, it makes up the difference between what it wants and what it can get by papering it over with debt, which in turn must be serviced by assuming that it can simply amp up the extraction when the extraction has already been maxed out. Meanwhile, the Real Economy falls behind because it’s already overexploited.

    In theory, investment is supposed to be about providing the financial means to increased production. In practice, it’s about locking in claims on production that can’t be met because the claims are excessive.

    Meanwhile, the Real Economy overexploits the natural environment to try to meet the demands of the FIC, which ultimately damages it and, in turn, decreases the degree to which the natural environment and the Real Economy can exploited. This process, driven by the greed of the FIC, is unsustainable and self-defeating. And this process has been going on so long, and so aggressively, that it’s about to bring down the whole self-destructive greedy system.

    Rentier capitalists are notoriously blind to all this because all they’re able to see are visions of bigger and better currency symbols, but that’s rentier capitalism. And if they want roast goose for dinner, the one that lays the golden eggs, well, who’s going to stop them?

    • Xabier says:

      Who’s going to stop us?

      Mother Nature: with a good spanking, and then sent up to bed without our suppers, to cry and wail in the dark……..

  8. implicit says:

    It used to be just the vix that shows these short temporary big spikes up, will the introduction of negative, or near negative rates create the inverse in ETF land from the millions starving for yield in R.E., food, companies, etc…? Probably, eventually, but eventually is a vague term.

  9. HR01 says:


    Thank you.

    Yes, the costs of NIRP remain even though the term ‘risk’ has been relegated to the dustbin. Retail investors only make reference of risk when couched in the context of missing out on the next move higher.

    Here in the U.S. the can continues to be kicked further down the road thanks to the global hunt for yield. Corporate debt issuance brisk this past week. Apple issued another $7B in long-term debt as did Disney. The vast majority of issuance was for refinancing purposes. Likewise as Wolf reported this week, the Fed shed $20B in assets due entirely to the decline in MBS holdings. So U.S. households are also kicking the can down the road. Rightfully so given that 30-year mortgages are about where they were three years ago (around 3.75%).

    Corporate America remains laser-focused on equity buybacks funded with debt. Some day perhaps market historians will label this era as The Slow-Mo LBO.

    • Bam_Man says:

      Brilliant observation.
      What we are currently witnessing will eventually (probably fairly soon) lead to the “Death of Equities”, as the vast majority of large public companies gradually LBO themselves. In the upcoming economic downturn these hyper-leveraged entities will all end up in bankruptcy, with common shareholders completely wiped out.

  10. robt says:

    Carney uses 10% as the crisis-point for fund liquidity; many countries’ current reserve rates for the banking industry indicate that’s considered adequate. Of course, banks presumably have assets of better liquidity and by definition, quality, but in a no-bid environment even quality doesn’t matter.
    Also, countries like Canada, with zero reserve ratio, make one wonder about the solvency of any institution, as witnessed in the last financial event. In a panic, reserve ratios mean little, except if they’re near 100%, and they’re gold (both literally and figuratively).

  11. DamonW says:

    “[The requirement] 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.”

    Did anyone else find this funny/sad?

    We’re to understand these so-called managers don’t have anything on hand to stress-test their own funds? Wouldn’t this be part of fund management in general? i.e. if X, Y or Z happens then what are the consequences for our portfolio?

    The mind boggles at what so-called “management” is actually doing to earn their fees at these funds.

Comments are closed.