In 2002, addressing Nobel Prize-winning economist Milton Friedman on his 90th birthday, former Fed chair Ben Bernanke acknowledged the role of the Federal Reserve in worsening the financial crisis of the Great Depression rather than helping it. He said, “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
True to his word, when he found himself in charge of the policy response to the financial crisis of 2007 to 2008, Bernanke took Friedman’s lesson to heart -- providing unprecedentedly accommodative monetary policy rather than the tightening the Fed had applied during the aftermath of the crash of 1929. The Fed funds rate has since been pinned at all-time lows, and further unorthodox policy, in the form of quantitative easing, has extended the Fed’s efforts to ease the effects of the crash and nurture the U.S. economy back to health.
Fed Funds Rate: Pinned Near Zero
As the U.S. economy has strengthened, and as financial assets have benefitted from the ample liquidity unleashed by the Fed’s policy measures, analysts and commentators have wondered when and how these measures may produce unanticipated and undesirable effects. For years after the crisis, the predominant fear was inflation, with some suggesting that the Fed’s policies would cause immediate and severe inflationary effects. Those effects never materialized, and it slowly became apparent that the immediate battle would be with deflation rather than inflation.
U.S. Year-Over-Year Consumer Price Index Growth, ex-food and energy
(We do believe that inflation will eventually emerge, but the presence of countervailing forces in the global economy makes timing that emergence a vexing endeavor.)
That leaves the question open of what unintended consequences there may be from the past seven years of experimental monetary policy by most of the world’s central banks.
Liquidity Risk Front and Center
With rates pinned near zero, the post-crisis era has been one in whichsavers have found themselves pushed into an increasingly anxious search for yield -- at the same time that borrowers, especially corporateborrowers, have found themselves emboldened to raise lots of money at rock-bottom prices. These two trends have met one another in the rise of a new breed of fixed-income ETFs.
These ETFs provide daily, apparently plentiful liquidity to investors -- even when the liquidity of the underlying instruments is very low. Fixed-income ETFs now hold some $330 billion in assets. Holders include not just retail investors, but institutions seeking to bridge the gap between the liquidity demanded by their investors and the illiquidity of the underlying bonds.
The mechanics of ETFs allow for daily liquidity. When intraday trading brings the price of the ETF’s shares out of line with the price of the underlying instruments which that ETF tracks, large institutions step in to arbitrage the differential by buying or selling blocks of the underlying assets. In the case of bond funds, those underlying assets are bonds. If they are illiquid bonds -- and trades in many corporate and developing-market bonds can take weeks to settle -- there may be a marked divergence between the ease with which holders of the ETF can sell shares, and the ease with which the “arbitrageurs” can work.
What “Liquidity” Really Means
“Liquidity” is a vague word. What it really refers to is not just an asset’s ability to be sold quickly, but its ability to be sold quickly at a price not far removed from the price of its last trade. We could not meaningfully say that an asset is “liquid” if its trading price responds catastrophically to a stampede of sellers.
The rise of fixed-income ETFs may present another example of the kind of “financial alchemy” that allowed the miraculous transmutation of sub-prime mortgages into triple-A rated instruments. In short, investors in these instruments may be buying into an illusion of liquidity, the illusion that under all circumstances, they will be able to sell them in an orderly fashion and at a reasonable price. Precisely when liquidity is most desired, it may vanish. The “limit” of the liquidity of the ETF holding illiquid instruments may prove to be the liquidity of those underlying instruments themselves… and in a crisis, those underlying instruments may decline precipitously in value as buyers step away. When met with redemption orders, the computers that handle ETF rebalancing must sell underlying assets, and the computers have little regard for price.
In good times -- such as the times that have characterized the last seven years of low rates and easy monetary policy -- the shares of such ETFs may exhibit deceptively low volatility -- so investors in these shares may be wholly unprepared for the downside volatility that may emerge when the market in the underlying securities becomes stressed. It is also worth remembering that “liquidity risk” is a form of risk for which investors ought to be compensated -- and we don’t believe that the market is offering investors in these bond ETFs enough compensation for the real risk they are taking on.
Regulation and Contagion
Two further thoughts:
First, if the “new” liquidity of bond ETFs is illusory, it is replacing “real” liquidity that was once provided by the bond desks of major investment banks. Post-crisis legislation has rendered them unwilling to hold substantial bond inventories and the risks those holdings entail. That deep liquidity has quietly evaporated, and has been replaced with the liquidity of ETFs -- which may vanish in the kind of crisis where the old market-makers once stepped in to stabilize markets. Much post-crisis financial legislation has been constructive -- but this is one area where the unintended consequences may ultimately prove undesirable. This is another reason why individual and institutional investors may be unpleasantly surprised by the volatility that strikes during the next crisis.
Second, bond ETFs might not be the only ETFs that suffer from these dynamics. In the event of market turbulence, investors who cannot liquidate their bond or bond ETF holdings in an orderly fashion may instead liquidate their other holdings -- bringing them under pressure as well. We’re thinking particularly of ETFs holding small-capitalization stocks, or so-called “liquid alternative” ETFs that try to reproduce the strategies of hedge funds for retail investors.
What’s an Investor to Do?
Hedge funds have a variety of ways to prepare themselves to benefit from the volatility that may be in store -- short-selling shares of bond ETFs, buying options that will benefit from a selloff in bond funds and their underlying securities, or buying credit-default swaps that may increase in value as the market views their associated bonds to be more likely to default.
Retail investors have fewer options. There are a small number of inverse bond ETFs which rise when their corresponding bond ETFs fall. In any event, we would counsel investors to carefully evaluate the real liquidity of the underlying assets in any bond funds they hold -- if they must hold bonds at all. If investors hold any bond funds, they should make sure the fund’s holdings are of deeply liquid, short-dated instruments -- and they should recognize that what is “liquid” in today’s calm may not be liquid in tomorrow’s turbulence.
Investment implications: Individual and institutional investors, hungry for yield, have crowded into bond funds in the hope of strong returns and low volatility. Corporate borrowers have taken advantage of historically low interest rates to issue bonds. The confluence of these trends, and the questionable liquidity of these instruments, may create great volatility in the event of future market stress. In our view, it is not a question of “if” -- it’s a question of “when.” As a Fed rate hike draws closer, we suggest that investors evaluate their bond fund holdings very carefully to evaluate whether or not they are being adequately rewarded for the liquidity risk to which they are exposed.
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