Ever since bond market liquidity became the topic du jour across Wall Street (just a few short years after it was first raised in these pages), analysts, pundits, and reporters alike have begun to question what might happen should investors who have piled into mutual funds and ETFs (especially fixed income products) suddenly decide to sell into illiquid secondary markets.
Some have suggested, for instance, that if corporate bond fund managers were suddenly inundated with a cascade of redemptions, the absence of dealer liquidity in the secondary market could create the conditions for a firesale.
The problem, as we’ve been keen to point out, is that when fund flows are one-way (i.e. everyone is selling), fund managers must either i) meet redemptions with cash, or ii) trade the underlying securities. Note that the latter option is so undesirable in illiquid markets (indeed, trading large blocks into illiquid markets poses a systemic risk), that some fund managers are now lining up emergency liquidity lines with banks so that they can at least meet an initial wave of selling with cash and avoid, for a time at least, sparring with illiquidity.
In his latest Investment Outlook, Bill Gross addresses the above, describes what events might trigger a retail exodus (thus tipping the first domino), and says investors should hold enough cash to ride out the storm without participating in a firesale caused by rising rates or some manner of exogenous shock.
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From “It Never Rains In California”:
Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash. Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance.
While Dodd Frank legislation has made actual banks less risky, their risks have really just been transferred to somewhere else in the system. With trading turnover having declined by 35% in the investment grade bond market as shown in Exhibit 1, and 55% in the High Yield market since 2005, financial regulators have ample cause to wonder if the phrase “run on the bank” could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks. Thus, current discussions involving “SIFI” designation – “Strategically Important Financial Institutions” are being hotly contested by those that may be just that. Not “too big to fail” but “too important to neglect” could be the market’s future mantra.
Submitted by Tyler Durden
Full report at Zero Hedge
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