The Cost of Moving at Sub-Treasury Speed
A fire sale can happen quickly, or it can unfold in slow motion. It all depends on what the holder is selling because time moves differently for various asset classes.
And if a security normally trades relatively slowly, it takes a lot of extra money to try to speed things up.
Treasuries, for example, move rapidly. Corporate bonds, on the other hand, trade about 3,000 times more slowly than U.S. government debt. So it would be much more expensive to quickly liquidate a pool of company debt than it would for Treasuries.
That’s one of the conclusions of a research paper presented by Albert S. Kyle, a finance professor at the University of Maryland, this week at the Federal Reserve Bank of Atlanta conference in Amelia Island, Fla. He highlighted how time is the main distinguishing factor between different securities and how they trade.
The paper’s point is critical to anyone who invests in corporate-debt funds because it raises a question about relying on a quick exit from slow-moving securities. While mutual funds promise investors the ability to redeem their capital daily, the underlying securities often move much more slowly.
So far, this liquidity mismatch hasn’t caused a crisis during market hiccups, even given the billions of dollars of mutual-fund money that has poured into corporate debt markets since 2008. And it seems unlikely to cause a systemic seizure in the near future because fund managers are taking actions to prevent selling debt in a down market, including holding more cash and securing credit lines.
But it does raise a question about the fairness of allowing investors to redeem as much money as they want as quickly as they want without any extra charge.
If investors need speed and require their money back immediately, it seems logical they should pay for the privilege. After all, there’s an implied cost for daily withdrawal of money from corporate-debt funds, and during volatile times, that cost spikes. It doesn't seem right to burden the remaining investors with that expense. In fact, existing investors might even consider fleeing themselves to avoid being left holding the bag, igniting a run.
Consider for a moment that corporate bonds are losing value quickly, either because of a sudden unexpected default or a macroeconomic event. Investors who decide to exit funds should either give fund managers longer than three to seven days to come up with their money or pay a premium for exiting quickly.
Conversely, when such bonds are rapidly gaining value, the premium for withdrawing money daily would be much lower or even nothing.
Kyle and his fellow researcher, Anna Obizhaeva of the New Economic School in Russia, derived a formula to gauge the cost of selling an asset based on historical patterns and current volatility. While the formula may not end up being the definitive way of determining an asset's implied liquidity cost in real time, it's a starting point. It shows the connection between the expense of trading and the time investors expect to execute transactions.
And it highlights how investors wishing to withdraw money in a down market should expect to wait to receive their cash or prepare for a bigger loss. Mutual-fund investors should embrace this concept. It would protect their returns and the health of the financial system.
To contact the author of this story:
Lisa Abramowicz in New York at firstname.lastname@example.org
To contact the editor responsible for this story:
Daniel Niemi at email@example.com