Back in May, some were perplexed as to why Vanguard – the veritable bastion of responsible investing and a presumed island of safety in a sea of market perils – was lining up billions in emergency liquidity to tap in the event its bond funds were hit with a sudden wave of redemptions.
As Reuters reported at the time, “Vanguard, the second-largest U.S. ETF provider, lined up its first committed bank line of credit last year and now has a $2.89 billion facility backed by multiple banks and accessible to all of Vanguard’s funds, covering some $3 trillion in assets, the Pennsylvania-based fund company [said]. The new setup is to ‘make sure that funds will be available in time of market stress when the banks themselves may have liquidity concerns.'”
As we explained, the committed credit lines are a sign that it may be unfair to apply the “Chicken Little” label to those who warn that the combination of illiquid corporate credit markets, booming issuance, bond ETF proliferation, and the Fed-induced hunt for yield is a recipe for disaster. That is, the sky might actually be about to fall and it looks like even the SEC knows it, as Mary Jo White proposed a set of new guidelines on Tuesday designed to address the risk posed by illiquid secondary markets for corporate credit. Here’s Reuters:
Under Tuesday’s plan, mutual funds and ETFs will need to devise plans to ensure they can meet redemption demands from investors during periods of market stress.
These plans will require funds to classify and review the assets in their portfolios based upon how quickly they could be converted into cash.
The plan would also permit, but not require, mutual funds to use “swing pricing,” a process in which a fund’s net asset value reflects the costs associated with trading so those costs can be passed to shareholders.
Swing pricing is meant to protect existing shareholders from dilution that can come from purchases and redemptions, and would only be triggered in certain market conditions.
Finally, Tuesday’s plan calls for additional disclosures related to swing pricing use and how the liquidity of a fund’s assets is classified.
The problem, as we began detailing years ago and as we have discussed on far too many occasions lately to count, is that an acute lack of market depth sets up the potential for a firesale in the event bond fund flows become non-diversifiable. In other words, should everyone suddenly want out causing a massive unidirectional flow of funds, managers will be forced to tap the underlying markets for the assets the fund holds and if those markets are exceptionally thin, well, transacting in size could trigger a meltdown.
In order to avoid that scenario, Vanguard (and others) are looking to pay out redemptions with borrowed cash and sell off the bonds later when market conditions (hopefully) become more favorable.
That’s probably a bad idea for any number of reasons and we’ve included our full guide to phantom fund liquidity below which discusses the entire issue at length, but for now, consider the following from WSJ, who endeavored to discover which bond mutual funds would be at risk should investors come calling in droves.
Via WSJ:
Some of the largest U.S. bond mutual funds have invested 15% or more of their money in rarely traded securities, a practice that runs counter to long-held Securities and Exchange Commission views on the funds, an analysis by The Wall Street Journal shows.
The finding is one indicator of inconsistency in how fund managers calculate the liquidity in their portfolios, a hot-button issue for investors and regulators. By the Journal’s measure, 10 of the 18 largest funds that invest meaningfully in corporate debt have significant holdings of seldom traded bonds. All the funds in the analysis said they are compliant with SEC liquidity guidelines.
Bond buyers are concerned the funds could cause market turmoil if they try to sell these illiquid investments to meet redemptions, and the SEC is expected to propose new rules Tuesday to address the topic.
The crux of the problem is that mutual funds own more bonds that seldom trade than ever before, but they still promise to pay out investors within seven days of redemption of their shares.
“In some sense we have a crisis in waiting,” said John Ramsay, acting director of the SEC’s trading and markets division from 2012 to 2014, at a bond-fund conference in June. “There’s been a buildup of inventory at asset managers, and the dealers are less willing to [trade],” he said.
The Journal’s analysis, based on data from Morningstar Inc. and MarketAxess, of large bond mutual funds indicates that most funds with at least one-quarter of investments in corporate bondholdings exceed the 15% threshold, and some are more than 30% invested in bonds that would take more than seven days to sell. Actual illiquid holdings may be higher after accounting for investments in other illiquid assets, like corporate loans, which the Journal didn’t track.
Companies operating large bond funds with more than 15% invested in bonds that trade sporadically include American Funds Inc., BlackRock Inc., Dodge & Cox, Loomis Sayles & Co., Lord Abbett & Co. LLC and Vanguard Group, according to the Journal’s analysis.
Bond mutual funds have tripled in size over the past decade, attracting individual investors with the chance to invest in hundreds of securities at once. But mutual funds also expose shareholders to losses if other investors sell shares of the funds in large quantity, a likely outcome when interest rates rise, depressing bond prices.
Illiquidity is one measure of that risk. The harder it is for fund managers to sell bonds to pay for redemptions, the bigger the losses for those still invested in the fund. Under current regulations, funds aren’t required to tell investors the portion of their investments they consider illiquid.
Needless to say, all of the fund providers mentioned in the article vigorously disputes WSJ’s assessment.
“The liquidity determination of fixed-income securities does not lend itself to a simplistic, one-factor analysis,” Dodge & Cox CEO Dana Emery angrily said.
Maybe so, but it certainly doesn’t seem like a coincidence that Vanguard has four funds on WSJ’s list just as it lines up nearly $3 billion in emergency liquidity that would allow it to meet the first wave of redemptions with cash should a selloff materialize and should market conditions for the funds’ assets prove to be particularly inhospitable.
So for now, mark this down as still more evidence that between i) the herding effect created by seven years of ZIRP, ii) the possibly irresponsible creation of bond ETFs whose marketing materials suggest to investors that somehow a vehicle that pools assets can be more liquid than the underlying, and iii) the unintended consequences of regulation designed to do away with “evil” prop traders, we have come away with a scenario that is frighteningly akin to the proverbial crowded theatre.
All that’s left now is for someone to yell “fire.”
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Full guide to phantom fund liquidity
Two months ago, in “ETF Issuers Quietly Prepare For Meltdown With Billions In Emergency Liquidity,” we outlined the rather disconcerting circumstances that have led some large fund managers to quietly line up emergency liquidity facilities that can be tapped in the event of a sudden retail exodus from bond funds.
“The biggest providers of exchange-traded funds, which have been funneling billions of investor dollars into some little-traded corners of the bond market, are bolstering bank credit lines for cash to tap in the event of a market meltdown. Vanguard Group, Guggenheim Investments and First Trust are among U.S. fund companies that have lined up new bank guarantees or expanded ones they already had, recent company filings show,” Reuters reported at the time, in a story we suspect did not get the attention it deserved.
At a base level, these precautionary measures are the result of the interplay between central bank policy and the unintended consequences of the post-crisis regulatory regime. ZIRP creates a hunt a for yield and simultaneously incentivizes companies (especially cash strapped companies) to tap the bond market while borrowing costs remain artificially suppressed. Clearly, this is a self-fulfilling prophecy. The longer rates on risk free assets remain near, at, or even below zero, the more demand there is for new corporate issuance (the rationale being that at least corporate credit offers some semblance of yield). More demand means rates on corporate credit are driven still lower, and once yields on high grade issues get close to the lower limit, yield-starved investors are then herded into HY.
All of this supply in the primary market comes at a time when liquidity in the secondary market for corporate credit is non-existent thanks to the shrinking dealer books that resulted from the government’s (maybe) well-meaning attempt to crack down on prop trading. The result: a crowded theatre with a tiny exit.
This situation has been exacerbated by the proliferation of bond ETFs which have allowed retail investors to pile into corners of the fixed income world where they might not belong.
All of the above can be summarized as follows.
“MF assets too large versus dealer inventories” (via Citi)…
… clear evidence of “structural damage in corporate bond trading liquidity” (via JP Morgan)…
… and the rapid growth of bond funds in the post-crisis world (via BIS)…
So given the above, the question is this: if something were to spook the market – a rate hike cycle for instance, or an October revolver raid on HY energy names, or an exogenous geopolitical shock – causing an exodus from these funds, what would happen to prices if fund managers were suddenly forced to transact in size in an illiquid secondary market in order to meet redemptions?
“Nothing good”, is the answer.
The solution is to avoid selling the underlying bonds – even when investors are selling their shares in the funds.
But how is this possible?
To a certain extent, outflows in one fund can be offset by inflows to another. These “diversifiable flows” are one happy byproduct of the great ETF proliferation. Here’s a refresher on how this works courtesy of Barclays.
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Portfolio Products Replace Dealer Inventory
While diversifiable flows limit the risks to portfolio managers in principle, the reality of the high yield market is more complicated. Managers have specific views on tenor, callability, sectors, covenants, and, most importantly, individual credits, such that actually finding buyers for specific bonds can be quite difficult. In the pre-crisis period, dealers ran large inventories that effectively facilitated the netting of flows across funds (Figure 1). A fund with an outflow would sell bonds into the dealer community, and funds with outflows would buy bonds out of the dealer inventory. When inventory is large, the fact that the specific bonds bought and sold did not match was largely irrelevant. Funds with outflows could sell the bonds of their choice, and the funds with inflows could pick investments from the large variety of inventory held by dealers.
The matching problem has become more acute as dealer inventories have declined. Even funds can net flows in principle, dealers are much less willing to warehouse bonds, and are much more likely to buy only when they believe they can quickly offload the risk. Under this scenario, the fact that flows can theoretically be netted is of little practical use to fund managers – actually netting individual bonds is extremely difficult, particularly in the short time frame required by funds offering daily liquidity to end investors.
This is where portfolio products come in. Investors can use portfolio products to fund outflows/invest inflows immediately and execute the necessary single-name bond trades over time as liquidity in the underlying bond market allows (Figure 2). In this scenario, funds with inflows and outflows simply exchange portfolio products, sidestepping the immediate need to trade single-name corporate bonds.
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Ok great, so ETFs provide a kind of “phantom” liquidity if you will. There are two problems with this:
- It only works when flows are diversifiable. Once flows become unidirectional, it all goes out the window.
- It makes the underlying markets even more illiquid.
Here’s how we put it last month in “How Fund Managers Use ETF Phantom Liquidity To Avert A Meltdown“:
In other words, if I’m a fund manager, the idea that ETFs provide liquidity rests on the assumption that when I experience outflows, someone else will be experiencing inflows and thus I can sell ETFs and avoid offloading my bonds into an illiquid corporate credit market. Put another way: I am depending on new money coming into the market to fund redemptions from previous investors who are exiting the market, all so that I can avoid liquidating assets that are declining in value and that I believe will be difficult to sell. There’s a term for that kind of business. It’s called a ponzi scheme and just like all other ponzi schemes, when the new money dries up (so, for example, when HY bond ETF flows are all headed in the wrong direction), the only way to meet redemptions is to get what I can for the assets I have and when the market for those assets is thin (as the secondary market for corporate credit most certainly is), I may incur substantial losses.
Note also that the more often ETFs are used as a way of avoiding the underlying bond market, the more illiquid that market becomes, making the situation still more precarious in the event of a panic.
So what is a fund manager to do?
This is where we come full circle to the emergency liquidity lines mentioned at the outset. In order to avoid tapping the underlying illiquid bond market in a situation where flows are unidirectional, fund managers may instead pay out redemptions in borrowed cash.
This is, to quote Citi’s Matt King, “creative destruction destroyed.”
Only worse.
That is, this represents the willful delay of a long overdue episode of creative destruction layered atop another delay of the much needed Schumpeterian endgame. Stripping out the metaphysics and philosophy references, that can be translated as follows: this strategy is yet another example of delaying the inevitable. If fund managers are forced to tap these liquidity lines it likely means investors have found a reason to sell en masse and if that reason turns out to be something that permanently impairs the value of the underlying bonds (as opposed to a transitory, irrational panic) then all the funds are doing by borrowing to meet redemptions is employing leverage to stave off the recognition of losses, which is ironically the same thing (in principle anyway) that the companies whose bonds they’re holding have done to stay in business. It’s a delay-and-pray scheme designed to avoid selling the debt of companies whose similar delay-and-pray schemes have run their course.
In closing, it’s important to note that no fund manager in the world will be able to line up enough emergency liquidity protection to avoid tapping the corporate credit market in the event of panic selling in the increasingly crowded market for bond funds.
In other words, when the exodus comes, the illiquidity that’s been chasing markets for the better part of seven years will finally catch up, and at that point, all bets are officially off.
