Bond bubble puts global financial system at risk
IMF warns fixed-income funds are vulnerable to liquidity shocks
Bond funds holding assets worth about $1.7tn could face difficulties in repaying investors promptly if volatility increases, according to the IMF, which warned that problems in fixed-income markets could potentially destabilise the global financial system.
The warning coincides with mounting fears that a dangerous pricing bubble has developed in fixed-income markets where bonds worth $15tn — about a quarter of the debt issued by governments and companies globally — are trading with negative yields.
Negative yields imply that prices have risen so high that investors will get back less than they paid, via interest and principal, if they hold the bond to maturity. Creditors, in effect, pay to hold debt.
This bizarre reversal of normal practice has triggered alarm bells because bonds are a core holding for institutional investors worldwide.
Concerns among regulators that bond funds might struggle to meet repayment requests by investors have been amplified by recent liquidity problems involving Neil Woodford, H2O and GAM.
Many bond fund managers have reduced their holdings of cash and other liquid assets that provide little or no income in an effort to improve returns. This so-called hunt for yield has driven up demand for lower quality assets that could prove more difficult to sell if market conditions deteriorate.
The IMF examined a sample of 1,760 bond funds (about 60 per cent of the $10.6tn in globally outstanding fixed-income assets) to determine if they would still be able to meet the most severe monthly outflows which they had registered since January 2000.
It concluded that almost one-sixth of all fixed-income fund assets would face a “liquidity shortfall”, implying that their managers would not have sufficient cash, liquid assets or credit immediately available to repay investors in the event of a repeat of their largest monthly redemption.
The IMF also noted that the weakest one-fifth of fixed income funds could face severe liquidity shortfalls which exceeded 20 per cent of their assets.
The average liquidity shortfall across bond funds has increased by about a third over the past two years and the total shortfall across the fixed-income sector is estimated to have reached $160bn (if all funds were to experience a simultaneous liquidity shock).
“Declines in holdings of liquid assets raise questions about fixed-income funds’ ability to absorb redemption shocks,” said Tobias Adrian, the IMF’s financial counsellor.
The problems were even more widespread among high-yield funds that invest in lower-quality corporate debt. Almost half of all high-yield fund assets could face a liquidity shortfall if their manager was confronted with a repeat of their biggest monthly withdrawal since 2000, said the IMF.
The IMF warned that if bond funds were unable to meet redemption requests, this could spark fire sales where managers dump assets to raise cash, which would inflict losses on other investors and “increase the risk for the financial system in the extreme case”.
Ultra-low interest rates introduced by central banks after the financial crisis have encouraged a huge rise in debt issuance by governments and companies over the past decade.
But up to 40 per cent of the $19tn of debt owed by companies is now at risk of default if there is a global economic downturn, according to the IMF’s analysis. This could lead to widespread losses for bond funds.
The IMF said policymakers should also consider introducing eligibility criteria based on credit quality and liquidity metrics for the inclusion of assets in fixed-income portfolios to reduce risks.
It also suggested that asset managers should be required to better match the redemption period of their funds to the liquidity profile of their portfolios to mitigate the potential for fire sales.
This would require sweeping changes in current practice in Europe where the vast majority of mutual funds (Ucits) offer investors daily liquidity despite not having a formal obligation to do so.
The IMF’s analysis in its annual Global Financial Stability Report follows similar criticisms by other regulators.
Mark Carney, governor of the Bank of England, said in June that investment funds that hold illiquid assets but offer daily redemptions to investors were “built on a lie”.
The BoE reiterated its view that liquidity vulnerabilities are a widespread problem because many funds offer daily redemptions while investing in assets that can take weeks or months to sell in an orderly way.
“Large-scale redemptions from funds could test markets’ ability to absorb asset sales, amplifying price moves, transmitting stress to other parts of the financial system, and disrupting the availability of finance in the real economy,” said the central bank.
The UK’s Financial Conduct Authority last month set out new rules that will apply from September 2020 to funds that invest in hard-to-sell assets. They will be subject to deeper disclosure rules, enhanced depositary oversight and a requirement to produce liquidity risk contingency plans. These funds will also be required to halt trading if there is uncertainty about the value of 20 per cent of their assets. This rule will initially apply only to open-ended property funds but the FCA is considering extending this standard more widely across the fund industry.
Pascal Blanqué, group chief investment officer at Amundi, Europe’s largest asset manager, said the vast bond-buying programmes introduced by central banks in response to the global financial crisis were partly responsible for the liquidity problems in fixed income markets. “As the share of assets held by central banks rises, there is an increased scarcity of bonds available for investors to purchase, squeezing liquidity in some markets,” he said.
His comments were echoed by Marc Ostwald, chief economist at the brokerage ADM Investor Services. “Central banks have crowded out private sector fixed-income investors from government bond markets. Zero-interest rate policies have also forced investors to move into riskier bond investments in a reach for yield,” said Mr Ostwald.
US bank loan funds sold to retail investors present an acute example of potential liquidity problems, according to Moody's, the rating agency. “Bank loans trade as private transactions for which settlement times typically average two weeks. Bank loan mutual funds have a structural mismatch between the assets they hold and their liabilities to investors,” said Stephen Tu, senior credit officer at Moody's.
Mr Ostwald said post-crisis regulations had made the banking sector safer while also pushing risks previously held by banks into the investment funds industry. “What previously were risks within the banking system may metastasise into illiquidity risks in the investment funds sector,” he said.