GOOD generals know that the next war will be fought with different weapons and tactics from the last. Similarly, financial regulators are right to worry that the next crisis may not resemble the credit crunch of 2007-08.
The last crisis arose from the interaction between the market for mortgage-backed securities and the banking system. As investors became unsure of the banks’ exposure to bad debts, they cut back on their lending to the sector, causing a liquidity squeeze. Since then, central banks have insisted that commercial banks improve their capital ratios to ensure they are less vulnerable.
Might the next crisis originate not in the banking system, but in the bond market? That is the subject of a new paper* from the Bank of England. The worry centres on the “liquidity mismatch” between mutual funds, which offer instant redemption to their clients, and the corporate-bond market, where many securities may be hard to trade in a crisis. The danger is that forced selling, to return money to investors, leads to big falls in bond prices, creating a feedback loop.
If that concern seems fanciful, think back to the summer of 2016, when British mutual property funds had to suspend redemptions in the wake of the EU referendum vote. Fund managers simply could not sell properties fast enough to pay off their investors.
The corporate-bond market is a particular concern because it is much less liquid than the equities market. That liquidity has fallen in recent years, because banks have become less willing to act as market-makers. This reluctance is rooted in the regulations imposed after the last crisis, which require banks to hold more capital.
The Bank of England’s study focused on European mutual funds that own investment-grade bonds (the safest category). Since 2005, the worst month for redemptions in this sector occurred in October 2008, when outflows reached the equivalent of 1% of assets under management each week. The sell-off was accompanied by a rise in bond spreads—the gap between the yield on investment-grade bonds and that on government debt—of around a percentage point.
Some of that increase was obviously caused by a deterioration in the economy—investors realised that bond issuers were more likely to default. But the bank reckons that around half the shift was the result of a decline in liquidity. In other words, bond investors demanded a higher yield to compensate them for the difficulty they might face in selling their holdings.
What if the sell-off is greater than it was in 2008? After all, near-zero rates on cash must have pushed a lot of investors into corporate-bond funds in recent years. Some of those investors may be using bond funds as “rainy day” money and will thus be reluctant to sit tight if their savings are losing value.
Others could step in to buy the bonds. Long-term holders like pension funds and insurance companies are obvious candidates to do so, although they tend to be slow to react. Hedge funds are more nimble bargain-hunters but they often depend on financing from the banks, and that may not be available in a crisis.
Finally, the banks themselves could step in, but they face capital charges on their market-making activities. The moment could come, the bank suggests, when “dealers reach the limit of their capacity to absorb those asset sales”. This would be the “market-breaking point”. And that stage could be reached when redemptions equal 1.3% of net assets of corporate-bond funds—in other words, only 30% higher than during the 2008 crisis.
A sell-off in corporate bonds ought not to be as damaging as the mortgage-related crisis of 2008. Investors don’t tend to use borrowed money to buy such bonds, and the big asset-management companies don’t back funds with their own capital. Corporate bonds also comprise only a small part of most portfolios. But it could still be traumatic if bond funds need to be suspended. That could undermine retail investors’ confidence in the liquidity of the mutual funds on which many depend for their retirement income. The bank is right to be alert to the risks.
* “Simulating stress across the financial system: the resilience of corporate-bond markets and the role of investment funds”, Financial Stability Paper No 42