In the IMF’s Global Financial Stability Report published earlier this week, it portentously declared it is time for advanced economies to move beyond dependence on the liquidity crutch of easy money stimulus and show their capacity for self-sustaining growth marked by increased corporate investment and employment growth.
While the IMF sees promising signs of a return to normal rates in the US, rebuilding of bank capital ratios and reduced fragmentation in Europe, it also considered several risks to the world economy, including the scale and speed of potential outflows from emerging markets and the delay in resolving the balance sheets of indebted euro-area corporates necessitated by keeping banks alive.
The IMF also mentions the obvious risk to financial stability from asset bubbles and the chase for yield amid widespread repression of policy rates, highlighting signs of weakening underwriting standards in US high-yield bonds and leveraged loans.
A previously overlooked risk the IMF has now chosen to give prominence to is one Euromoney has reported on extensively: sharply reduced bond-market liquidity, as dealers reduce inventory, become less willing to trade and investors find it harder to turnover large positions, even as the bond market grows rapidly. This has coincided with the search for yield driving retail investors into new structures, such as credit mutual funds and exchange traded funds (ETFs), that are particularly vulnerable to runs.
The IMF shows that the share of corporate bonds and syndicated loans held by households, mutual funds and ETFs now exceeds the share that traditional institutional investors, such as insurance companies and pension funds, hold directly or even indirectly through collateralized loan obligations (CLOs).
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The concern is that if investors seek to withdraw massively from mutual funds and ETFs focused on relatively illiquid high-yield bonds or leveraged loans, the pressure could lead to fire sales in credit markets. The IMF shows that heavy outflows from corporate bond mutual funds and ETFs in May to June 2013 were accompanied by a rise in high-yield corporate bond spreads, in contrast with previous episodes when rising Treasury yields, implying improved credit conditions, were accompanied by lower credit spreads.
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The IMF points out: “Further liquidity risks could arise because leveraged loan mutual funds rely on bank lines of credit to meet redemptions, as loan sales typically take 20 to 25 days to settle. “Banks that extend these lines to loan funds may also have their own exposure to leveraged loans via balance sheet holdings, CLO warehouses, or total return swaps. In case of a disruption to the leveraged loan market, banks could be more likely to reduce lines of credit, generating an adverse feedback loop.”
The IMF further points out that mutual funds and fixed-income ETFs also have a liquidity mismatch with the over-the-counter assets they reference, and that occasionally this liquidity mismatch creates a feedback loop that can exacerbate sell-offs, particularly when dealer inventories are too lean to act as a buffer.
It states: “There is a risk that fire sales in illiquid markets could spill over to other sectors of the bond market and to a broader range of investors, particularly if it affects highly leveraged investors (such as mortgage real-estate investment trusts and hedge funds), which rely on short-term funding.”
Euromoney will report in the May edition on the latest innovations dealers and investors are working on as they grapple with the problem of reduced liquidity, not just in corporate bonds but also in supposedly more liquid government bond markets.
“There is considerable attention among all bond market participants now on reduced dealer inventory,” one fixed-income head at a leading bank tells Euromoney. “And don’t forget that US regulators’ recent imposition of a higher leverage ratio than that set by the Basel Committee has particular consequences for highly rated government bond markets including treasuries, which, with their zero risk-weights, were previously little impacted by risk-weighted capital charges.”
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| Niall Cameron, global head of credit trading at HSBC |
As Euromoney pointed out last year, if liquidity is as bad as most bond investors claim and dealers admit, then regulators might need to look at bond mutual funds’ promise to their end-clients of daily liquidity and whether there is an assumption among fund managers that they’ll get away with not actually supplying this. Investors might have to accept other changes to fund structures if the corporate bond market, which has grown so fast since the financial crisis, should now have negligible secondary support from bank dealers as interest rates start to rise.
Niall Cameron, global head of credit trading at HSBC, pointed out in the autumn: “Many funds are segregated on the basis of yield as determined by underlying credit quality – so, high-grade bond funds, high-yield funds, emerging market bond funds, distressed funds. The greater the credit risk, the higher the required yield.
“The same thinking may increasingly have to apply to liquidity risk. So funds might be composed to offer higher yields for investing in illiquid bonds of the same underlying credits that in aggregate provide lower yields to clients of funds invested in their more liquid instruments. And these funds might have varying lock-ups to stagger potential redemptions.”
