Ever since bond market liquidity became the topic du jour across Wall Street (just a few short years after it was first raised in these pages), analysts, pundits, and reporters alike have begun to question what might happen should investors who have piled into mutual funds and ETFs (especially fixed income products) suddenly decide to sell into illiquid secondary markets.
Some have suggested, for instance, that if corporate bond fund managers were suddenly inundated with a cascade of redemptions, the absence of dealer liquidity in the secondary market could create the conditions for a firesale.
The problem, as we’ve been keen to point out, is that when fund flows are one-way (i.e. everyone is selling), fund managers must either i) meet redemptions with cash, or ii) trade the underlying securities. Note that the latter option is so undesirable in illiquid markets (indeed, trading large blocks into illiquid markets poses a systemic risk), that some fund managers are now lining upemergency liquidity lines with banks so that they can at least meet an initial wave of selling with cash and avoid, for a time at least, sparring with illiquidity.
In his latest Investment Outlook, Bill Gross addresses the above, describes what events might trigger a retail exodus (thus tipping the first domino), and says investors should hold enough cash to ride out the storm without participating in a firesale caused by rising rates or some manner of exogenous shock.
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From “It Never Rains In California”:
Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash. Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance.
While Dodd Frank legislation has made actual banks less risky, their risks have really just been transferred to somewhere else in the system. With trading turnover having declined by 35% in the investment grade bond market as shown in Exhibit 1, and 55% in the High Yield market since 2005, financial regulators have ample cause to wonder if the phrase “run on the bank” could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks. Thus, current discussions involving “SIFI” designation – “Strategically Important Financial Institutions” are being hotly contested by those that may be just that. Not “too big to fail” but “too important to neglect” could be the market’s future mantra.
Aside from the obvious drop in trading volumes shown above, the obvious risk – perhaps better labeled the “liquidity illusion” – is that all investors cannot fit through a narrow exit at the same time. But shadow banking structures – unlike cash securities – require counterparty relationships that require more and more margin if prices should decline. That is why PIMCO’s safe haven claim of their use of derivatives is so counterintuitive. While private equity and hedge funds have built-in “gates” to prevent an overnight exit, mutual funds and ETFs do not. That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances. But even in milder “left tail scenarios” it is price that makes the difference to mutual fund and ETF holders alike, and when liquidity is scarce, prices usually go downnot up, given a Minsky moment. Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers’ hands are tied to perform their historical function of buyer of last resort. It’s then that liquidity will be tested.
And what might precipitate such a “run on the shadow banks”?
- A central bank mistake leading to lower bond prices and a stronger dollar.
- Greece, and if so, the inevitable aftermath of default/restructuring leading to additional concerns for Eurozone peripherals.
- China - “a riddle wrapped in a mystery, inside an enigma”. It is the “mystery meat” of economic sandwiches - you never know what’s in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.
- Emerging market crisis - dollar denominated debt/overinvestment/commodity orientation - take your pick of potential culprits.
- Geopolitical risks - too numerous to mention and too sensitive to print.
- A butterfly’s wing - chaos theory suggests that a small change in “non-linear systems” could result in large changes elsewhere. Call this kooky, but in a levered financial system, small changes can upset the status quo. Keep that butterfly net handy.
Should that moment occur, a cold rather than a hot shower may be an investor’s reward and the view will be something less that “gorgeous”. So what to do? Hold an appropriate amount of cash so that panic selling for you is off the table.