As central bankers seek to wean markets off quantitative easing and exit the dangerous experiment of negative rates, they increasingly fret about the resilience of credit markets. How worried should they be?
The US Treasury’s Office for Financial Research, the European Central Bank and the Bank of England have all issued warnings in their financial stability reports voicing concern over whether we might see fire sales that could amplify risks at what is probably the end of a 30-year bull market in bonds.
It is true that investors in fixed-income mutual funds have played a growing role in funding economic recovery as banks focus on deleveraging and repair. In the eurozone, financing from the credit market has more than offset the €500bn funding gap left by banks. As a result, mutual fund holdings of corporate bonds doubled in both Europe and the US since 2009.
However, corporate bond funds have never been particularly flighty and have withstood periods of stress far better than the critics imagine. The bond rout of 1994 saw investors redeem 5 per cent in the worst three months, according to Morgan Stanley and Oliver Wyman. No crisis since has seen redemptions of more than 6 per cent in a quarter, versus cash and near cash on standby of 5 per cent to 10 per cent today.
Bond funds have just passed another real life stress test. Despite a fall over the past three months of $3tn in the value of bond markets, they have seen no more than 2 per cent redemptions.
One reason is the objectives of those who invest in the funds. Over half of funds in the US and UK are held in tax-incentivised retirement savings accounts, so run risk is extremely low. Another is that asset managers have been on heightened alert about the reduced liquidity provided by bond dealers as financial regulation has reshaped the ecosystem. Many funds have adapted their asset allocation, trading tools and run internal fire drills to ensure they can meet their commitments.
What’s more, corporate bond funds are only a part of the credit puzzle. New Fed data show mutual fund holdings of corporate bonds are just 17 per cent of US-held bonds while sterling-focused bond funds represent just 15 per cent of UK bonds.
But there is one other crucial development that many are missing: the development of exchange traded funds may have indirectly made mutual funds more stable. Dynamic investors — like asset allocators looking to change exposures to major events — increasingly use ETFs. This means that ETFs are far more prone to big swings in investor appetite than mutual funds.
This does not mean there should not be keen regulatory focus. I have argued in these pages that bond funds should be subject to internal stress tests to ensure they can honour redemptions — because there will always be outliers.
The International Organization of Securities Commissions is looking to announce further global standards on how to test corporate bond funds in mid-2017. The strongest standards would be ones that allow firms to use models to quantify risk, take into account the behaviour of different investors and the historical experience of illiquidity during moments of market stress.
So if bond funds are not a risk to financial stability as we exit QE, what should the focus be?
First the players, such as ETFs and clearing houses, whose role has been significantly enhanced from the reshaping of the global markets should be high on the agenda for 2017. Second, market regulators should take stock of the large number of positive changes in their rule books to ensure that the cumulative impact of new standards safeguard investors without disproportionately hurting fixed-income market efficiency.
One particular area ripe for reappraisal is how to report and trade large blocks of corporate bonds. Asset managers and banks have become concerned about the depth of liquidity, particularly in periods of stress, and raised this with Finra in 2015. Equity markets have for many years been able to operate with integrity having exemptions for large “block” trades. However, fixed income reporting rules prohibit this in the US and this could form a welcome part of the reappraisal of Dodd-Frank and related rules. Alas, new Mifid rules will also introduce this challenge to Europe just as rates are set to rise.
Third, policymakers should focus on stress testing and galvanising action at banks where risks still overhang from bad debts, such as in parts of the eurozone. Finally, investigate approaches that look at the whole system in the round. That is why I am particularly looking forward to the BoE’s proposed simulation of how credit markets may function when banks, insurers, pension funds and mutual funds are all together put under stressed scenarios.
Huw van Steenis is global head of strategy at Schroders and a member of the World Economic Forum Agenda Council.