Fund boards, management go on high alert around bond liquidity
U.S. fund firms are taking extra measures to make sure they don't get stuck holding hard-to-sell bonds in the event that fixed income markets see a massive race to the exits when interest rates start to rise.
Over the past few months a growing number of asset managers, including Neuberger Berman, Natixis Global Management and T. Rowe Price have been testing their funds against various market scenarios, building cushions of cash, shorter-duration bonds and other liquid securities, and regularly discussing risks with their boards.
The concern is this: As the Federal Reserve begins to raise rates, which many expect will begin to happen next year, investors will rush to sell bonds as their value drops in a rising interest rate environment. Historically Wall Street banks have been the buyers of these bonds, but regulations and capital requirements imposed since the financial crisis have forced these firms to slash their inventories.
"I look around and ask 'at the end of the day how easy would it be to sell what I own?', and the answer is it is much more challenging," said Jason Brady, a fixed income portfolio manager at Sante Fe, New Mexico-based Thornburg Investment Management, which has $70 billion in assets under management, $17 billion of which is in fixed income.
Wall Street's biggest banks don't believe the Fed will raise rates until the middle of next year at the earliest. In a survey taken in early October, 14 of the 19 primary dealers, or the banks that deal directly with the Fed, said they expect the first rate hike by June 2015, with borrowing costs rising to 1 percent at the end of that year.
But fund managers say they are already seeing signs of it getting harder to buy and sell bonds.
Many managers were spooked in mid-October, when the yield on 10-year Treasury notes fell quickly to 1.865 percent, their lowest level since May 2013.
"When all of a sudden the most liquid market out there isn't liquid, it's worrisome," Brady said.
Thornburg and T. Rowe are among a number of firms that have increased their allocations to cash to provide their portfolios with a buffer in the case of a liquidity crunch. Thornburg's $1.3 billion Strategic Income Fund (TSIAX.O) has increased its allocation to cash to 13 percent from 10 percent last year and has also increased its holdings in shorter-duration bonds and high grade investment debt, Brady said.
T. Rowe's High Yield Fund (PRHYX.O) has 3 percent in cash, up from 1 percent a year ago, said Mark Vaselkiv, manager of the fund.
Instead of cash, Natixis has built up a reserve of as much as 20 percent in some of its mutual funds in higher quality, non-U.S. securities, such as bonds denominated in Australian and Canadian dollars, said David Lafferty, chief market strategist at Natixis. As of September 30, Natixis had $894.3 billion in assets under management and its subsidiary, Boston-based Loomis Sayles & Co, had $223.2 billion.
Firms, like New York-based Voya Investment Management, which uses third party managers to subadvise its funds, now give high-yield bond managers up to three days notice before it makes big redemptions out of those funds to make sure they can get the money in an orderly and timely fashion, said Paul Zemsky, CIO of multi-asset strategies at Voya, speaking on Tuesday at the Reuters Global Investment Outlook Summit in New York.
One particular area of concern regarding liquidity is in bank loan funds, which typically invest in loans made to non-investment-grade companies, because these loans can take weeks to settle. To address this, T. Rowe, like many firms, has a line of credit that it can use in the event of a liquidity crunch. Over the past year, the firm has doubled its line of credit to $300 million, Vaselkiv said.
Concerns about bond liquidity have made it up to the fund board level at companies, George Walker, chief executive officer of New York-based Neuberger Berman, told attendees of the Securities Industry and Financial Markets Association's annual conference in New York on Oct 10.
"It is a bigger part of the dialogue at our boards," Walker said.
Similarly, at the request of board members and its parent company, Natixis, Loomis Sayles' head of investment risk management earlier this month held a session on bond market liquidity for the Natixis fund board of trustees, detailing new monitoring procedures they have implemented to gauge liquidity, Lafferty said.
Regulators are also more routinely talking to traders about the issue, executives said. On Wednesday, T. Rowe's bond traders met with the Securities and Exchange Commission to discuss bond liquidity, Vaselkiv said.
T. Rowe looks at days where there was the most intense redemption activity and tests how long it would take to liquidate its high yield fund. "We look at how much could we do in one day, one week and one month," he said.
In the end, however, the best way managers can get comfortable with liquidity concerns is to be prepared to hold on to the bonds in their portfolio for the long-term, said Margie Patel, senior portfolio manager at Wells Capital Management, speaking Thursday at the Reuters summit.
"Liquidity is illusory for most bonds," she said. "The only time you need it is when you can't get it."