Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Safety is an expensive pursuit. People pay billions of dollars to insurance companies every year to shield them in case of accidents, floods and disease.

But when it comes to investing, there is often an agreed upon, and in fact desired, assumption of some level of risk in return for some larger reward. Protecting against potentially sharp loss is possible, but it comes with a price, one that investors may not want to pay.

Debt investors are facing a new layer of potentially costly protection against the much-feared bond-liquidity crisis. Newly proposed U.S. rules may soon require mutual funds to regularly test their holdings to ensure they’re holding enough easy-to-sell assets to meet mass withdrawals within three business days.

The proposal, from the Securities and Exchange Commission, requires funds to assess how long it would take to “sell and settle a position without altering the bond’s price” after accounting for the size and nature of the holdings, according to Deutsche Bank analysts Oleg Melentyev and Daniel Sorid in a report they put out on Monday.

The proposed rules approach liquidity as if it were a concrete concept that could be measured perfectly and disclosed to investors by categorizing debt into neat boxes of ease or difficulty to sell. 

"The reality is that it’s a vague concept, driven by psychological factors perhaps as much as it is by market technicals,” Melentyev said in an email message.

This is a fuzzy calculation, relying on various hypothetical situations that would spur bond investors to run for the exits. It’s hard to know which type of debt would be easiest to sell at any given time because financial crises tend to be idiosyncratic and unpredictable.

For example, debt of Hewlett Packard and AT&T have been among the most active corporate bonds in the past few months. Will they be just as liquid in six months? A year? Two years? What if one of these companies runs into trouble? Fewer investors would want to step in to buy the bonds, making it tougher to sell a significant amount of these bonds without moving the market.

 The SEC’s proposal has good intentions. There’s been a good deal of concern about the flood of cash into mutual funds, with shares that settle within three days, that’s gone toward buying corporate debt that trades infrequently. While banks are shrinking their balance sheets and reducing risk, the threat of severe losses has migrated to individual and institutional investors, which have fueled an unprecedented expansion of the $8 trillion U.S. corporate-bond market.

 Regulators are worried that investors don’t understand the risk they’re taking as trading fails to keep pace with the huge growth in outstanding debt. But investors also probably don’t fully understand the cost of reducing the risk of a credit traffic jam.

They’re already accepting lower returns to own the most-traded bonds as opposed to those that transact less frequently. The iBoxx U.S. Liquid High Yield index has lost 0.3 percent this year compared with a 0.4 percent gain on the Barclays U.S. Corporate High Yield index. Investors would stand to lose additional profits to higher administrative costs under the SEC’s proposal.

It’s important for investors to understand the risks they’re taking as much as possible. But it’s also necessary for them to consider the costs of mitigating that risk and make an informed judgment about their threshold for loss. The flip side of risk is reward, and there’s nothing wrong with that as long as everyone’s eyes are open. Safety is always an option, it just doesn’t pay that much.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net