A Liquidity Risk, But not the One You Thought
Which of the below statements is true:
1) It’s becoming more difficult to trade in U.S. credit markets.
2) There’s a growing amount of trading in U.S. credit markets.
If you chose No. 1, congratulations! You’re correct!
If you chose No. 2, congratulations! You’re also right!
How is it possible for both to be accurate? And what does that say about the big players in the bond market?
As to the first question, investors are well aware that certain bonds trade a lot and others almost never do. U.S. corporate-debt trading volumes have risen 56 percent since 2006, Moody’s data show, even as investors complain widely about their struggles in moving around in $8 trillion of this debt. The size of each trade has become smaller, especially among bigger transactions, so it often takes longer to make big allocation shifts in real bonds. But it’s easier to trade through exchange-traded funds and in smaller sizes of popular debt.
Concerns about bond-market liquidity have focused largely on mutual funds and whether they are prepared to handle volatility if they start experiencing significant withdrawals. This is especially salient now because they own 25 percent of corporate bonds outstanding, compared with just 13 percent before the financial crisis, Moody’s data show. U.S. mutual funds that focus on corporate bonds have attracted more than $20 billion of deposits this year, according to data compiled by Bank of America.
Mutual fund managers often decide what bonds to buy based on how long they can afford to hang onto them. Lack of liquidity and volatility may actually pose a greater risk to mutual funds' slicker cousins, hedge funds and others that follow similar strategies. Some hedge funds, which need to generate bigger returns to justify their hefty fees, don’t really know how sticky their money is and haven’t planned for wholesale withdrawals of their clients' money. This has become more relevant as assets at these funds have shrunk by the most since 2008 amid the recent market turmoil, according to Hedge Fund Research data.
Hedge funds with more than $16 billion have announced shutdowns so far this year, data compiled by Bloomberg show. In August, Bloomberg News reported that investors in Carlyle Group’s Claren Road Asset Management, which focuses on credit, asked to pull about 48 percent of the hedge fund’s $4.1 billion in assets.
Mutual funds, meanwhile, have had a more stable source of deposits of late despite all the worrying by the International Monetary Fund and the Securities and Exchange Commission that their investors are all going to flee at the same time.
Many mutual-fund managers have prepared for redemptions by holding bigger cushions of cash and easy-to-trade assets. Hedge funds, on the other hand, are more of a black box when it comes to their strategies and holdings.
If the time comes when withdrawals force big players to cash out of the market, it seems more likely that hedge funds, not plain-vanilla mutual funds, will be the ones with a liquidity problem on their hands.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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