— Paul Amery's Blog

Central bankers can’t outlaw systemic risk

According to the Financial Times (subscription required) the US central bank is concerned about the potential for a run on retail bond funds. The Fed has discussed imposing mandatory exit fees on those holding funds as a way of managing this run risk.

The FT reminds us that US retail investors have pumped over $1 trillion into bond funds since early 2009. Central bankers worry about investors buying funds that promise immediate liquidity while investing in potentially illiquid underlying assets like corporate bonds.

Ironically, the increasingly desperate search for yield by income-deprived investors is squarely the result of central banks’ own zero interest rate and quantitative easing (QE) policies. In recent months there’s been a top-of-the-market feel about bond ETF inflows, for example, with buyers focusing on the highest-yielding (and junkiest) part of the market, like leveraged loan funds.

I wrote in 2012 that regulators were soon likely to focus on fund liquidity risk. There’s an inherent tension between the promise of the retail fund “wrapper”—to allow investors to enter and depart at will—and the underlying assets of some funds.

In Europe, fund exit fees already exist in a rough and ready way in the form of redemption gates in fund prospectuses. If more than 10% of investors in a retail (UCITS) fund want to leave in a single day, the fund administrator can postpone redemptions until the next day.

Interestingly, some ETF issuers have told me that they’ve waived this right in the past, deciding not to halt occasional daily redemptions exceeding 10% of fund assets, presumably for fear of negative publicity.

ETFs, which are traded intraday on stock exchanges, provide a pressure valve in the sense that secondary market trading in a fund with suspended redemptions might continue—but it would be in limited volumes and presumably at a big discount to the fund’s net asset value.

We saw this happen on a small scale during a mini-panic in US-listed corporate bond ETFs last June, with one market-maker stepping away from its promise to process investors’ sell orders.

In the US mutual fund market, suspending redemptions is trickier because of the liquidity promise built into the 1940 Act structure. Fund managers must meet redemption requests within seven days and a suspension of redemptions is possible only in extreme circumstances.

At least 85% of fund assets have to be invested in “liquid securities” (I’m not sure how leveraged loan ETFs, which comply with the 1940 Act, can claim to be doing that).

You can see why the Fed is worried about run risk in junk bond mutual funds, particularly since there’s evidence that US investors are flightier than their European counterparts.

By cracking down on the banks, which can no longer hold large inventories of bonds for trading purposes, regulators have shifted risk to bond mutual funds. Now they are concerned about the consequences of their own policies.

I’ve written in the past about the potential for a crash in this sector. In particular, the shaky dealing infrastructure underlying bond funds seemed (and still seems) to me like an accident waiting to happen.

All the same, I feel uneasy about regulators’ current proposals to intervene so directly in the fund market. Investors buy funds knowing they may lose money. You can’t outlaw market bubbles and busts: they happen. If central bankers really think they can manage away all systemic risk then the next crash will be all the more violent.

  • Ben Golub

    By creating exit fees that are decent proxies for actual transactions costs being incurred by a fund, the exiting investor who might be “running” from the asset has to absorb the full cost of his exit. This both shields the remaining investors from economic harm as well as providing the mechanism that will ultimately end the run, namely that it might become increasingly expensive. There are fund vehicles in other jurisdictions like the UK and AUS that have such mechanisms, such as dual NAV funds, swing pricing, or the ability to charge investors upon exiting. These structures are simply better mouse traps for individual investors and the “system” as a whole.

    • pamery

      Hello Ben, thanks for the feedback and for pointing out that mechanisms for allocating exit costs equitably already exist in some jurisdictions. In the case of the ETF market the redemption costs set by issuers for authorised participants presumably serve a similar purpose. I suppose a question is whether regulators are able to set any new mandatory redemption fees at a meaningful level and how they will distinguish between different types of fund.