Open-Ended Bond Funds Can Cause Systemic Instability - In Extremis, They Can't Liquidate Fast Enough

May 20, 2019 11:03 AM ETAGG, BND, PTY, BOND, RCS, BTZ, DBL, PCM, SCHZ, BHK, SPAB, JHI, HIPS, IUSB, AGGY, FBND, JMM, VBF, PAI, GTO, SAGG, AGGP, GBF, VBND, DWFI, AGGE, HQBD, EAGG, JAGG, JCPB, JMST, PPTB2 Comments

Summary

  • We know that banking itself is fragile as assets cannot be recouped as fast as depositors withdraw money - possibly.
  • Closed-end funds don't suffer from this problem.
  • Open-ended funds possibly can - it depends on the liquidity of the market they're invested in.

Firth Ratings has issued a warning - a general one, not about any specific fund or provider of them - concerning open-ended bond funds. The essential and basic idea of such funds leaves them potentially vulnerable to the same problems banking is. That of a bank run where withdrawals outpace the ability to collect on assets. We have, in fact, seen these in slightly different funds, open-ended property investment ones. The concern is real.

Here's Fitch:

Open-ended bond funds are a potential risk to global financial stability given their rapid growth and increasing liquidity mismatches and credit risk, Fitch Ratings says in a new report.

Here's the basic problem, described as we understand and know it from banking. The bulk of deposits in banks are sight deposits - we can go and ask for our money back anytime. Sure, there are 30- and 180-day CDs and all that but they're a fraction of the market. But the banks are obviously lending out that money. And they're doing so for longer terms than we are lending to the banks with our deposits.

Sure, there is on sight lending too - in theory, the bank can ask for certain loans back any time they want to, overdrafts in British banks for example. But the bulk of banking is in term loans, up to 30 years for mortgages for example. They're funding those long-term loans with short-term money. In fact, the economist Brad Delong says this is the essence of banking, borrowing short and lending long. If you do this, borrow for shorter periods of time than you lend out for, then you are doing banking; if you're not, then you're not.

This introduces a fundamental instability into the system. If we all turn up and ask for our money back at the same time, then the bank can't pay us - the money's out in those longer terms loans and mortgages. Sure, the bank keeps a bit of cash on hand, a fraction, which is why the system is called fractional reserve banking. But it's entirely possible for a bank to be completely solvent, they can pay everyone back over time, but illiquid, they can't pay everyone today. This is what happens in a bank run.

We have a system to deal with this, the central bank - for us, the Federal Reserve - lends cash to the bank and takes security over the loans.

What Fitch is pointing out is that it's not just banks that potentially have this problem. Any system where withdrawals are more liquid than the underlying assets can suffer from it. Thus open-ended bond funds can:

Open-ended bond funds provide daily liquidity for investors but are increasingly investing in longer-dated or lower-quality securities as bank regulation has reduced the supply of market liquidity and investors are seeking extra yield while interest rates remain low. This exposes funds to liquidity pressure if there is a spike in redemptions, potentially leading to forced asset sales and a run on the fund as investors pull out. The risks are most pronounced in purely credit-focused funds with less-liquid underlying assets, such as corporate loans and bonds. We estimate pure credit funds are about 15% of total global bond funds.

If we all turn up and ask for our money back at the same time, then the bond fund has to liquidate. But depending upon what sector the fund is in, it can or cannot liquidate either quickly or at reasonable prices.

If it's Treasuries - and Gilts, Bunds and so on - fund, then no problem. Those markets are liquid enough that to get to the sort of point that lack of liquidity, to cash in a position, is a big enough problem to worry about means that we've got other, very much larger, systemic problems to chew our fingernails over. However, corporate bond markets can often be very illiquid. Which is where the problem lies.

An example from a slightly different market:

There is a worrying whiff of investor panic in the news that a £2.9bn retail property fund has suspended redemptions. Retail investors had been rushing to cash in units in Standard Life's UK Real Estate Fund in the wake of the Brexit vote. The asset manager was forced to slam its gates in their faces today to protect the interests of all unit holders... Private investors favour open-ended funds for imagined low costs and flexibility. However, the funds lack the latter characteristic when dealing in illiquid investments, such as the commercial property that is the metier of the Standard Life vehicle. You cannot deal fast and in size in office blocks, as you can in blue-chip shares. Old-fashioned closed-end funds and real estate trusts have the virtue that investors can dump listed stock without making a call on underlying investments.

Yes, real estate is different from corporate bonds. But it's the same underlying problem. The liquidity promised to investors is greater - potentially at least - than that which exists in the underlying investments. A wave of redemptions can thus lead to significant repayment problems for the fund itself. Either it must liquidate at fire-sale prices or suspend redemptions.

The systemic risks here are for other people to worry about, not us. As investors, though, we do have to pay attention here. We all prefer open-ended funds, we must do otherwise they wouldn't have grown so much in recent years. But we've got to be aware that they do suffer from this problem that closed-end funds don't. In extremis, those promises of immediate redemption either aren't going to be kept or they will be but at distress prices.

The less liquid the underlying market, the greater this potential problem. Our decision-making should thus reflect this. If we are in for the long haul, we simply aren't going to liquidate the position until some sort of maturity event then this doesn't matter at all. If we are taking a position that we might want to reverse dependent upon market conditions, then we do, at the least, have to be aware of the point.

If that open-ended fund is in an inherently illiquid market - real estate as above, Fitch here warning about corporate bonds and the same point would apply to smaller municipal issues - then, in times of trouble, we're not going to get the liquidity promised by the fund. If that underlying is in a liquid market, say Treasuries, larger equities, then the promise can be kept to.

This isn't a deal breaker, it's just something we need to be aware of.

This article was written by

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Tim Worstall is a wholesaler of rare earth metals and one of the global experts in the metal scandium. He is also a Fellow at the Adam Smith Inst in London and an writer for a number of media outlets, including The Times (London), Telegraph, The Register and even, very occasionally indeed, for the WSJ. This account is linked with that of Mohamad Machine-Chian: https://seekingalpha.com/user/52914142/comments

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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