Open-end funds combined with highly illiquid assets could make for an explosive cocktail should global economic growth slow further and market volatility increase, analysts warn.
After a series of fund implosions in Europe this year, mutual funds and exchange-traded funds (ETFs) holding illiquid bonds and loans issued by highly leveraged corporations, rather than well-capitalized banks, could be the next source of financial-sector instability, and amplify market selloffs, analysts say.
The chief concern is that such funds will buckle during times of market stress and will be unable to deliver on a promise of liquidity.
“When you put completely illiquid, essentially privately placed debt, or even semi-liquid loans in meaningful size into a fund, it does create potential conditions like a cessation of the fund,” said Steven Oh, head of global fixed income and credit at PineBridge Investments, in an interview with MarketWatch.
Market liquidity in open-end funds has come into focus recently, after funds holding sizable slugs of hard-to-trade and difficult-to-value securities were forced to close in the U.K. and Europe after a rush of outflows. Those include, Neil Woodford’s flagship Equity Income fund and GAM’s absolute return bond funds.
More recently, H20 Asset Management, which held highly illiquid securities of companies associated with twice-bankrupt German financier Lars Windhorst, has seen billions of dollars leave its funds over these controversial links.
Shares in open-end mutual funds or hedge funds valued at net asset value, allow investors to take money in and out of the fund at their convenience. By contrast, investors in closed-end funds can only liquidate their assets by selling their shares in the fund to another investor, relieving the fund manager from unloading the funds assets to meet redemptions.
In particular, funds holding corporate bonds and other fixed-income assets have received attention recently because the underlying investments are less widely traded than government debt or stocks.
BCA Research estimated that open-end mutual funds and exchange-traded funds held around 16% of the corporate bond market in 2019, from 3% in 1990.
The danger of redemptions by investors in open ended funds is increased because active trading in corporate debt markets has dried up since the 2008 financial crisis, analysts say.
As Wall Street dealers have retrenched following the 2010 Dodd-Frank financial reform legislation, liquidity is often dependent on brokers and money managers who don’t have the inventory or incentive to make a market in corporate debt, leaving sellers in the lurch, said Dan Fuss, manager of Loomis Sayles Bond Fund, in an interview with MarketWatch.
As a result, even mutual funds, as well as hedge funds, could be vulnerable to market meltdowns. In a July report, the Financial Policy Committee at the Bank of England said that liquidity mismatches between funds and their assets could potentially turn into a systemic financial risk.
“Large scale redemptions from funds could result in sales of illiquid assets that may exceed the ability of dealers and other investors to absorb them, amplifying price moves, transmitting stress to other parts of the financial system, and disrupting the availability of finance to the real economy,” they said.
How these funds hold up during a period of high market volatility remains an open question. The time between an investor filing a redemption request and the deadline for a cash payout can prove treacherous for fund managers because large withdrawal amounts can amplify selling in illiquid debt markets, overwhelming buyers and creating sharp price swings.
This creates a negative feedback loop on Wall Street.
“During times of stress, mutual fund investors have an incentive to withdraw their money before other fund shareholders get the chance. Otherwise, they could be stuck holding a basket of illiquid corporate bonds,” wrote Ryan Swift, U.S. bond strategist for BCA Research.
Daily redemption requirements could become particularly problematic in the leveraged loan market, where sellers take around 14 days on average to settle a trade, according to Markit data.
That could disrupt the open-ended funds holding around $250 billion of leveraged loans in 2019, a sharp rise from $20 billion in 2007, according to the U.K. central bank.
It’s why some investors who say leveraged loans may not deserve the increased regulatory scrutiny assigned to the sector will nevertheless concede that it could be dangerous to pair such investments with open-end funds. Instead, mutual funds that cap the frequency of redemptions might be more suitable for holding such illiquid instruments.
“Any open-end fund with illiquid assets really shouldn’t be offering daily liquidity,” said Gershon Distenfield, co-head of fixed income at AllianceBernstein, told MarketWatch. “There is no real reason to offer a loan fund,” he said.
But so far, collapses of open-end funds have remained rare in the U.S.
Investors pointed to the blow-up of Third Avenue Management’s Focused Credit Fund in 2015 as an example though some argue it was a special case. The high-yield bond fund was forced to halt redemptions after its holdings were slammed by fears of growing defaults in the oil-and-gas sector and expectations for the Federal Reserve to raise interest rates at that time.
Seen by some as a textbook example of how an open-end mutual fund under pressure from outflows could eventually implode, others argue Third Avenue was a weak case study because it held outright distressed bonds, or debt issued by companies near bankruptcy, even though it advertised itself as a fund focused on sub-investment grade corporate credits. Wall Street also considers bonds that trade below 70 cents on the dollar as distressed.
“When Third Avenue had its issue, it had a higher number of illiquid assets than most competitors in the high-yield space,” said Tony Rodriguez, head of fixed income at Nuveen, told MarketWatch.
Doubts around open-end funds have also spilled over into ETF which can be traded daily. Such concerns gained traction back in December when retail investors panicked and cashed out of ETFs focused on the leveraged loan sector, according to Vincent Deluard, chief macro strategist at INTL FC Stone.
In the fourth quarter last year, a basket of leveraged loans recorded a loss of 3.5%, virtually wiping out its gains seen for much of the year, based on data from IHS Markit. The turmoil saw the Invesco Senior Loan ETF
briefly trade at a discount of 2% to its net asset value at the peak of the leveraged loan market’s weakness.
But the Bank of England said liquidity concerns around ETFs may be overdone given their small share of overall corporate debt markets.
Open-end mutual funds and ETFs aren’t completely defenseless though.
Large mutual funds can sometimes tap bank credit lines when they don’t have enough cash on hand. In effect, they borrow money to satisfy large redemptions, giving the fund managers time to sell their holdings and use the proceeds to repay the loaned funds.
Major providers of fixed-income exchange-traded funds like State Street and Vanguard have added lines of credit over the years, according to Reuters.