Investors Do Not Have To Wait For SEC Action On Bond Mutual Fund Liquidity - Self-Help Is Available

by: Martin Lowy

Some open-end bond mutual funds, mostly high yield funds, may be subject to liquidity risk.

The SEC has proposed new rules to help investors.

The proposed rules seem inadequate to me, but also are opposed by the industry.

ETFs do not have the same liquidity risks.

Consider self-help by switching from traditional open-end bond funds to ETFs with similar investment goals.

Both learned studies and popular articles have raised questions about the illiquidity of some bond mutual funds. A study by the Federal Reserve Bank of New York staff, released February 18, 2016, is the latest I have seen. The more alarmist of these studies say that bond mutual funds can be subject to runs and that in such circumstances, there is a "first mover advantage"-that is, those who get out first get better prices for their mutual fund shares.

I am not of the alarmist school. Open-end bond mutual funds that hold large percentages of illiquid issues are runnable. That is true. Third Avenue Focused Credit Fund, which I wrote about last December, was so illiquid that it almost inevitably had to suspend redemptions some day when investors sought to cash out in large numbers. But that fund was an outlier. Few, if any, other open-end funds invest quite so heavily in illiquid securities.

The SEC has taken notice of the issue, and in September 2015 it promulgated a proposed rule that would require funds to allocate their assets into six liquidity buckets and to disclose that allocation (page 65 of the SEC release). The proposed rule also would codify the SEC's guideline that not more than 15% of a fund's assets may be invested in highly illiquid securities, and it would require fund boards to adopt and administer liquidity management regimes.

Frankly, in my view, the SEC's proposal is too complex to do investors much good, and if there is a problem about runnability, the SEC's proposal would help but probably would not actually solve the problem.

Most of the mutual fund management community does not like the SEC's proposal despite its relatively light touch.

Industry comments on the proposal tend to focus on two issues: (1) the proposal is too detailed in its six-bucket, prescriptive approach, and (2) investment managers need to be able to remain flexible in their approach to liquidity issues because the subject requires changing approaches to changing markets. These two criticisms lead me to two criticisms of the industry approach. (For a list of comments on the proposed rule, see here.)

Principles based regulation

Point one is a version of the "principles based regulation" versus "prescriptive" regulation debate that has been going on for decades, at least. U.K. regulators are currently in thrall to the principles based approach, and they are getting good press from the financial industry as a consequence. Principles based regulation is, however, very light touch and basically allows market players who choose to do so to go through the motions of establishing glossy plans that high-paid consultants devise, then do relatively little except to go about managing as they choose. At some later time, something bad occurs, the regulators say the manager involved violated the principles, then litigation ensues and the defendant claims the regulator is engaged in standardless enforcement.

The industry defends this kind of regulation as pro-competition. In fact, at least in the liquidity case, it is anti-competitive because competition depends on users (investors in mutual funds) having information based on which they can distinguish between funds-and providers' liquidity policies should be a part of that information. A principles based approach provides no such information to investors.

Liquidity management needs to be flexible

The industry's point two is scarier by far. By asserting that liquidity management is, in effect, an art form, the industry suggests to me that some mangers will do it well and some will not. Those that do not do it well may jeopardize their investors' results, but investors have no way to discern in advance which managers will perform the function well and which will not. This industry position scares me a great deal more than the studies that pile assumption on assumption to reach a scary result. Rather than making the SEC's proposed rule look too prescriptive, the "this is an art, stay out of it" approach makes me want to regulate the hell out of it.

Make it simple and self-executing

If it were my SEC, I would back off the fairly light touch of the proposed regulation and would adopt instead a simple disclosure rule: Every bond mutual fund must disclose prominently the number of days it would take to sell (1) 10%, (2) 20% and (3) 30% of its portfolio based on the average daily trading in the security and the size of the fund's position. That would leave no discretion, would actually inform investors and therefore would be pro-competitive, and it would be relevant to what could happen in the real world. (One could argue that the percentages should be larger or smaller.)

My proposal would, the industry would argue, penalize large funds because they have larger holdings. But since larger holdings are more difficult to dispose of, the apparent penalty simply would reflect reality.

My proposal probably will not fly with the SEC because prescriptive regulation is out of style and is opposed by the industry.

Exempt ETFs

Some of the industry comments make a very important point, however. They say that ETFs should be exempt from the regulation because EFT architecture is superior and not runnable. I heartily concur. Here is what the comment of the Federal Regulation of Securities Committee of the American Bar Association (submitted February 11, 2016), in suitably pedantic prose, said about ETF architecture in this regard

"The Committee is also of the view that ETFs and ETMFs that create and redeem shares principally on an in-kind basis should be exempt from Rule 22e-4 [where most of the proposed requirements discussed above are housed]. The liquidity of the underlying securities in portfolios of ETFs or ETMFs does not have the same relevance to their operations as it does to other open-end funds because ETFs and ETMFs generally do not redeem their shares for cash. Instead, these ETFs and ETMFs generally transact with authorized participants on an in-kind basis through the exchange of creation units, which consist of a "basket" of underlying portfolio securities, for shares of the ETF or ETMF (or vice versa). Investors have the ability to sell their shares in the secondary market, and should an authorized participant gather enough shares to form a creation unit, the authorized participant can exchange the unit for the portfolio of underlying securities.

"The key distinction is that ETFs and ETMFs generally do not need to sell portfolio securities in order to meet redemptions; they simply can exchange the underlying securities, rather than cash, for the creation unit. In times of market stress, in fact, ETFs and ETMFs that transact on an in-kind basis can provide a major source of liquidity to the market.

By way of statistical support for its assertion regarding the difference in architecture, the committee offered this quotation from a Bloomberg article in a footnote:

"If Friday [December 11, 2015] was a test, then the fixed income ETF experiment appears to be working. . . . [The iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG)] saw outflows of $560 million on Friday, its third worst day ever. But this was only 13 percent of its total $4.3 billion in trading volume, meaning 87 percent of the trading didn't involve touching the underlying bonds. To put it another way, 87 percent of the trading was between two parties over an exchange and/or through a market-maker."

I would urge that the performance of iShares iBoxx High Yield Corporate Bond ETF on that date was a good indication of the soundness of the architecture. Indeed, it was one of the factors that convinced me to invest in HYG soon thereafter.

Investor action-self-help

The ETF architecture is indeed far better from a liquidity point of view, and EFTs should be exempted. But investors do not have to wait to see what the SEC does. Quite simply, the industry positions are sufficiently scary that many open-end bond mutual fund investors should move their money from traditional open-end funds to ETFs that invest in similar bonds. By doing so, many investors will achieve not only greater peace of mind regarding liquidity but also a lower expense ratio.

A bond mutual fund investor has four basic concerns: yield (net of expenses), interest rate risk, credit risk and liquidity risk. Removing liquidity risk from the list permits an investor to focus on the three major points more freely.

I have not done the research necessary to determine comparability between individual traditional open-end bond funds and individual ETFs in terms of the three remaining characteristics. But I urge investors who hold traditional high yield corporate and emerging market open-end bond mutual funds to consider this step. Five large (over $5 billion of assets) high yield open-end funds are:

American Funds High Income (MUTF:AHITX)

Blackrock High Yield Bond (MUTF:BHYIX)

Pimco High Yield (MUTF:PHYIX)

TRowe Price High Yield (MUTF:PRHYX)

Vanguard High Yield Corporate (MUTF:VWEAX)

These funds are managed by some of the best investment managers in the U.S., so I do not intend to be alarmist about these funds. But funds in this category may be subject to liquidity issues, and the same managers usually have ETFs with similar investment goals. Some smaller funds may be more exposed, depending on the characteristics of their portfolios.

Investment grade bond funds tend not to be subject to the same liquidity risks as high yield funds because they generally invest in larger issues that trade more frequently and, because they have less credit risk, tend to trade in narrower bands. But concerned investors may want to switch nevertheless. At the least, this is a good occasion to make sure your expenses are not too high and that you are not paying 12b-1 fees.

Chances are that your financial information provider has tools that will make this process fairly easy. Except for possible tax consequences (which actually might be favorable in some cases), the process of switching should not be costly, except to brokers who are feasting off 12b-1 fees paid annually by some traditional open-end bond funds.

Please note that government bond funds and ultra-short bond funds are not subject to significant liquidity risk, nor are some other traditional conservatively managed bond funds run by Vanguard and other major providers. But high yield bond funds in general seem to be subject to the identified risks, by comparison with similar ETFs.

Disclosure: I am/we are long HYG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.