Fund Managers Are Incubating a Future Bond Market Crash
(Bloomberg Opinion) -- As the pandemic started to shake the global economy in March, liquidity rapidly dried up in the world’s fixed-income markets. Regulators have identified fund managers as the key protagonists in the petrification. To limit the repercussions of similar future dislocations, they should focus on the practice of allowing clients to withdraw their money on a daily basis as ripe for a fix.
It’s hardly the asset management industry’s fault it’s in this predicament. In the wake of the global financial crisis, the guardians of financial stability expended so much energy trying to make the banking system safer they may have simply shifted market risks elsewhere.
New rules governing balance sheets have prompted investment banks to scale back the capital they commit to securities markets, rather than just acting as the go-betweens for buyers and sellers. Fund managers have stepped in to make up some of the slack. But the mismatch between how liquid their investments are and the custom of repaying customers on demand — and it is nothing more than a custom, albeit one so widespread as to appear inviolable — makes for a dangerous tinderbox during periods of turbulence like the one that arrived with a vengeance in March.
Market participants knew there was an accident waiting to happen. Last year Pascal Blanque, Amundi SA’s chief investment officer, put the prospect of market liquidity drying up on the list of things that keep him awake at night. The Bank of England warned that the asset management industry could create “an adverse feedback loop” in which lower asset prices increased constraints on solvency and liquidity, pushing prices lower still.
Both proved prescient. When in March financial markets were subjected to their biggest stress test in more than a decade some of the most liquid bond trading arenas were found wanting. The Bank of England estimates that the gap between bid and offer prices on 30-year U.S. government bonds widened by ten times; in long-dated gilts, the jump was almost as big.
The jolt was magnified because hedge funds had been borrowing in the repurchase market to fund government bond purchases and selling the associated futures contracts, arbitraging price differentials between cash securities and futures. When that price relationship broke down, hedge funds rapidly withdrew sapping liquidity just when the market needed it most.
The shock to corporate debt was even greater. Funds struggled to meet customer redemptions as buyers for credit products proved hard to find. Only massive monetary intervention by the world’s central banks got financial markets flowing again. As listed securities plummeted and trading dried up, nine U.K. money managers breached rules that limit holdings of unquoted securities to 10% or less, according to Financial Conduct Authority data obtained by my Bloomberg colleagues Silla Brush and Suzy Waite.
This freeze in trading is forcing a reconsideration of which asset classes are perceived as liquid, as well it should. For example, Mikko Mursula, CIO at Finland’s Ilmarinen Mutual Pension Insurance Co., says the fact liquidity was almost zero for a couple of weeks has prompted him to classify corporate credit as illiquid when assessing what’s easiest to trade during market turbulence.
The rules on unlisted investments are designed to protect investors from getting trapped in a fund overwhelmed by redemption requests that outpace its ability to sell assets, and the market overseers are aware of the problem. Just last week, the European Securities and Markets Authority said investment funds must do a better job of assessing and managing the liquidity of the assets they buy.
But that’s easier said than done. As events in March showed, securities previously deemed liquid can suddenly become hard to sell. That’s why regulators need to go a step further by revisiting rules covering daily redemptions. The asset management industry needs assistance to help itself out of its current predicament. It’s unlikely one fund manager will move away from daily liquidity unless everyone else has to. The rules need to change.
For at least one asset class where several funds were forced to halt redemptions even before the pandemic — real estate — the U.K. Financial Market Authority is already proposing that funds require up to 180 days of notice before allowing withdrawals. By forcing asset managers to abandon their pledge to allow daily cash-outs across the industry, regulators can remove the stigma associated with any one fund moving those goalposts.
It’s been a year and a half since then Bank of England Governor Mark Carney told lawmakers that “funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid.” The time to act is now, before the next market meltdown traps investors.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."
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