Junk-Bond Holders Ignore Losses on Illiquidity, BOE Says

High-yield bond investors may be risking declines of as much as $60 billion in the value of their holdings if a crisis prompts them to increase the premium they need to compensate for the illiquidity of the securities, according to the Bank of England.

While asset managers express concern that rules to make banks more resilient have reduced liquidity, rather than boost cash holdings they have looked for ways of getting out of positions quickly when they expect redemptions, central bank analysts wrote in their half-yearly Financial Stability Report. Investors also accept a lower premium for liquidity risk even as changes to the market’s structure indicate they should demand more, according to the Bank of England.

“There is a risk that current valuations are masking an underlying fragility,” the analysts wrote. “This fragility could be exposed if investors simultaneously sought to unwind their fixed-income positions in response to a common interest-rate or volatility shock.”

Asset managers offer to redeem clients’ investments on short notice while holding underlying positions that might take weeks to unwind, according to the London-based central bank. A shock that prompted high-yield investors to double the liquidity-risk premium they require to the levels of late 2012 would cause the price of the bonds to decline by about 3 percent “all else equal,” according to the Bank of England’s analysis.

The risk is that investors rushing for the exits might “adversely affect the supply of market-based finance to the economy,” according to the central bank.

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