IMF Finds Flaw in Bond Industry as Exiting Funds Too Easy

Investment firms made it easy for individuals to plow into infrequently-traded debt in good times. Perhaps they should make it tougher to exit in downturns.

That’s how analysts at the International Monetary Fund see it anyway. They say regulators should consider new policies to prevent a mass exodus from funds that own illiquid debt.

The concern is that investors in mutual funds and exchange-traded funds have become complacent because they can trade fund shares daily, even though their money has been locked up in assets such as high-yield bonds and loans. Trades in those markets can take weeks to complete.

“This mismatch between the liquidity promised to fund owners in good times and the cost of illiquidity when meeting redemptions in periods of stress is a concern and call for action by regulators,” Fabio Cortes, an economist in the IMF’s monetary and capital markets department, wrote in an e-mail this week.

In other words, assets that look relatively easy to trade now -- as the Federal Reserve holds interest rates near zero -- may be much more difficult to offload in a credit market that’s selling off.

This is especially concerning because investors have piled into riskier debt in search of extra yield, making mutual funds, ETFs and households the biggest holders of dollar-denominated corporate and foreign bonds. The investors now own about 30 percent of the debt, up from less than 20 percent in 2007, the IMF said in a report this month.

Exacerbating Downturn

The “sense of an ability to sell anything instantaneously contributed to the excessive leveraging and risk-taking that led up to the crisis,” Paul Volcker, the former Fed chairman whose calls to limit the ability of banks to bet with their own money inspired the rule that bears his name, said in an e-mail last week. “There is such a thing as too much liquidity.”

The risk has gotten the attention of the financial system’s global regulatory body. The Financial Stability Board is examining whether ETFs pose a threat to market stability when interest rates rise, Carolyn Wilkins, the Bank of Canada’s representative to the group, said in an interview at Bloomberg’s Toronto office on Sept. 23.

Mutual-fund and ETF investors may exacerbate a downturn in credit by withdrawing cash after seeing losses pile up, according to the IMF report. Individual investors have a “tendency to follow the herd,” the analysts wrote in the report.

Stress Tests

They suggest considering gates and fees to limit redemptions in a rout while noting there are drawbacks to both measures.

The IMF’s concerns are overblown, says Brian Reid, chief economist at the Investment Company Institute, which represents U.S. investment companies.

“There’s a disconnect between how funds work and how the IMF understands how funds work,” Reid said. “If you have an open-ended fund, you have to provide daily redeemability” under U.S. law.

Mutual fund and ETF investors provide a surprisingly stable source of cash and don’t move it around all that frequently, Reid said. This is especially true now, with a growing proportion of older Americans plowing into bonds as they approach retirement, he said.

Investors have funneled more than $900 billion into taxable-bond mutual funds since the end of 2008, according to ICI data.

Price Shocks

The U.S. Securities and Exchange Commission has also taken note of the issue amid bond-market volatility. Its investment management division advised mutual-fund managers to stress test portfolios to make sure they can meet redemption requests “over a number of periods,” according to guidance published by the regulator in January.

Stress tests should incorporate situations such as interest-rate increases, widening bond spreads and price shocks to fixed-income investments, the SEC said.

The IMF argues regulators should do more.

John Nester, a spokesman for the SEC, didn’t immediately respond to an e-mail seeking comment.

“These less-frequently traded markets have received a strong increase in inflows by mutual funds and ETFs, which have created an illusion of ‘flow liquidity,’” Cortes wrote yesterday. “At the same time, other measures of liquidity such as breadth and depth have deteriorated.”

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