Copying and distributing are prohibited without permission of the publisher.

Watermark

Exit fees on bond funds — a silly solution to a non-problem

By Jon Hay
17 Jun 2014

If companies fund in bond markets, what happens when bond investors dump the asset class? Federal Reserve officials are crying that something must be done. Should bond investors have to pay exit fees to pull money out of funds? There have been worse ideas, but not recently.

A new bogeyman stalks the financial world — a run on corporate bond funds.

US companies already obtain much of their debt financing from the bond market, and European companies are following suit. Financial policymakers and commentators are waking up to the fact that this arrangement may carry risks.

What happens if investors in corporate bonds — or in the funds that own them — suddenly all try to pull their money out at once?

Many observers fret that investment banks’ retreat from bond market-making, which regulators have made more capital-intensive, has narrowed the exit door from bond investments. If there is a sell-off, today’s impaired liquidity might mean any price fall could quickly become catastrophic.

Even without the liquidity problem, if the corporate sector relies on bond investors, it could be vulnerable if those investors stampede out of the asset class.

This could even be triggered, some fear, by a rise in interest rates, which would slash the value of bond portfolios and could scare savers.

Investors’ ability to withdraw money from bond funds on demand, some believe, makes these funds like banks — with short term liabilities and long term assets. Hence, they arguably pose a similar systemic risk.

Federal Reserve officials, the Financial Times reports, have discussed imposing exit fees on bond funds to deter investors from pulling money out. BlackRock, apparently, likes the idea — it’s hard to imagine why — but it has drawn raspberries from many who see it as punishing or coercing savers.


Long term for a reason

The economy’s reliance on non-bank funding — or shadow banking — involves real and important questions that policymakers should be worrying about, and considering solutions to.

But let’s not get carried away. The risk of a regulatory over-reaction is if anything more worrying.

First of all, corporate bonds are long term funding. Companies issue debt for two, five or 30 years precisely to spread out their refinancing needs and protect them against refinancing shocks.

Such a shock occurred in 2008-9 after Lehman Brothers’ collapse. For a few months there was very little corporate bond issuance — but there was some. In November 2008, BMW paid 8.875% for a €1.25bn five year bond. But it raised the money and the high coupon has not killed BMW.

If there is a run on corporate bonds, it may hurt holders of corporate bonds, but will only affect the borrowers if it is very prolonged and no alternative sources of finance are available.


Hikes will not blow up bonds

Second, fearing a collapse of the fixed income market when rates rise is juvenile. The vast majority of money invested in bonds is there because those investors want to take only moderate risk, in return for a predictable income. Those investors are not going to switch en masse to equities, which offer a completely different risk and reward profile, just because rates change — an entirely predictable event.

Yes, a rate rise will cut bond portfolio values — but only in mark-to-market terms. Unless they default, bonds have an intrinsic value — they pay interest and will be redeemed at par. Only investors that choose to sell will actually lose cash from a rate rise, though their portfolio statements may carry some red ink for a while.

Talking loosely about huge “losses” from rate rises confuses the issue — voluntary losses are not the same as forced losses from a default. Marking to market is supposed to be a warning signal, not a disaster in itself. And rate rises make investing in new bonds more attractive, not less.


No comfort blanket

Third, with or without a rate rise, investors that sell bonds at a loss are doing so by choice and can hang on to the bonds until maturity if they don’t like the going price.

The point of the bond market, compared with loans, is that it gives the investor greater possibilities of liquidity — but investors have never expected that liquidity should be guaranteed, or come without risk. If bond prices fall, that is the flip side of liquidity, and investors know that perfectly well.

Fourth, imposing exit fees on bond funds sounds like a ‘blue sky thinking’ idea that is fine to consider but should never be allowed to gain traction.

It amounts to imposing a loss on investors to deter them from doing something that could cause them a loss. If selling out of bond funds is going to cause a bond price collapse, that is itself a financial disincentive to sell. Adding an artificial penalty is not only illiberal but unnecessary, and would deter investment in those funds. In fact, it’s profoundly silly.


Keep banks and bonds apart

The great thing about securities markets — otherwise known as shadow banking — is that they are not systemic in the same way as banks. They hold savings that people can afford to lose, or can afford to wait to get back.

That is why a 48% collapse in the S&P 500 index, as in 2007-9, leads to a 2% decline in US GDP — and much of that happened when the banks became infected by securities losses.

If policymakers are worried about securities markets and non-bank investors being an unreliable source of finance — as they should be — let them make sure the banks are kept healthy, and safely separated from those markets. Safety comes from firewalls, not charging tolls for using fire escapes.

By Jon Hay
17 Jun 2014