No Exit From Bond Funds ? FYI: Copy & Paste 6/21/14:
Regards,
Ted
A well-thought-out exit strategy is vital to the success of a mission, as the recent events in Iraq demonstrate quite dramatically.
Given that unfortunate example, it might be well that the Federal Reserve appears to be thinking about the consequences of the end -- and eventual reversal -- of its massive experiment in monetary stimulation. Last week, the Financial Times reported that the central bank is mulling exit fees on bond mutual funds to prevent a potential run when interest rates rise, which, given the ineluctable mathematics of bond investing, means prices fall. Quoting "people familiar with the matter," the FT said that senior-level discussions had taken place, but no formal policy had been developed.
Those senior folks apparently didn't include Fed Chair Janet Yellen. Asked about it at her news conference on Wednesday, she professed to be unaware of any discussion of bond-fund exit fees, adding that it was her understanding that the matter "is under the purview" of the Securities and Exchange Commission.
That nondenial denial leaves open the possibility that some entity in the U.S. financial regulatory apparatus is indeed mulling bond-fund exit fees. The Financial Stability Oversight Council established by the Dodd-Frank legislation oversees so-called systemically important financial institutions, or SIFIs, which include nonbank entities. And, indeed, the FSOC has considered designating asset managers as SIFIs, as Barron's has noted previously ("Why Fund Firms Aren't Too Big to Fail," June 2).
To Dan Fuss, the longtime chief investment officer at Loomis Sayles, the exit-fee story seemed like a "trial balloon." But, he added, "from a practical point of view, I don't think it has a snowball's chance in hell, given the resistance from the retail distributors of mutual funds."
Still, he continued, "it won't make me very popular -- but I think it's a good idea." That's from someone whom I would call the Buffett of bonds. Like his fellow octogenarian in Omaha, Fuss has lived through more than a few market paroxysms and has been able to take advantage by putting money to work opportunistically during panics. Unlike the head of Berkshire Hathaway, Fuss also has had to contend with outflows from his flagship Loomis Sayles Bond fund and the firm's other corporate-bond funds, as happened during the 2008 financial crisis. For staying the course during those dark days, Fuss was named Morningstar's Fixed-Income Manager of the Year in 2009.
The latter vantage point no doubt informs his endorsement of the concept of exit fees for bond funds. As the FT quoted former Fed Governor Jeremy Stein, bond funds give investors "a liquid claim on illiquid assets." That is most acute for open-end, high-yield bond funds, Fuss says, and extends to exchange-traded funds "in less liquid areas," which would apply to junk-bond and bank-loan ETFs.
It is a fact of financial life that most bonds are relatively illiquid, in part owing to their bespoke nature; every bond has its own unique coupon rate and maturity, plus possible features such as call options, seniority, and security, even among the same issuer. In contrast, every common share of most companies is identical (with exceptions for stocks with multiple share classes). Multiple buyers and sellers of the same item is economists' definition of a perfect market, as with a commodity such as wheat. Big, listed stocks come close; bonds, given their granular nature, don't.
The problem of liquid claims on illiquid assets is etched into American culture in the Christmas-time classic film, It's a Wonderful Life. Faced with a run on his savings-and-loan, Jimmy Stewart pleads with his depositors that there's little cash in the till because the money is invested in the townfolks' mortgages and businesses. The practical solutions to this conundrum: deposit insurance and having central banks act as lenders of last resort.
Those facilities don't apply to bond funds now, and didn't to money-market funds in 2008. Following the Lehman bankruptcy, the Reserve Fund "broke the buck," with its net asset value falling below $1 a share. The resulting run on that money fund and others exacerbated the crisis as this source of funds to the money market dried up.
Officials fear that bond funds could represent "shadow banks," the FT writes, intermediaries subject to runs but without resort to the backstops available to banks. Yet, the irony is that the rush into bond funds is a result of the Fed's own policies of pinning interest rates to the floor, which spurred investors to seek income wherever they could find it. As a result, bond funds have ballooned to $3.5 trillion -- with a T -- according to the most recent data from the Investment Company Institute. That's close to the Fed's securities holdings, which total $4.1 trillion.
Statistical evidence of that reach for yield comes from a research paper from Bank of Canada economists Sermin Gungor and Jesus Sierra (which was passed along by Torsten Slok, chief international economist at Deutsche Bank Securities).
Not surprisingly, low rates spurred bond funds to increase the credit risk in their portfolios to boost returns. Canadians, it's safe to assume, are no less desirous of maintaining investment income than are their neighbors to the south.
But with investors having stampeded into bond funds, would exit fees be effective at keeping them from stampeding for the exits at the first sign of higher yields and lower prices? Research suggests otherwise. And, ironically, it comes from within the Fed itself.
According to a New York Fed staff paper by Marco Cipriani, Antoine Martin, Patrick McCabe, and Bruno M. Parigi (and surfaced by Zerohedge.com), impediments to redemptions could actually spur bond-fund investors to sell first and ask questions later. In other words, exit fees or "gates" to discourage redemptions could backfire.
In Sartre's No Exit, hell is famously defined as "other people." The crisis that might ultimately await bond-fund investors is the prospect of being stuck with their fellow shareholders as yields rise and prices fall, rather than paying a ransom to escape. The existential choice facing bond-fund investors is whether to stay and face that prospect, or exit while they can -- if they are not prepared for a long-term commitment.
THE SUMMER SOLSTICE just arrived in the Northern Hemisphere, putting the sun highest in the sky. And, appropriately, the major stock-market averages closed the week at records, notably the Standard & Poor's 500 and the Dow Jones Industrial Average, which approached another round-number milestone: 17,000.
The latest liftoff came after Fed Chair Janet Yellen made clear that neither rising inflation nor soaring asset prices would deter the central bank from monetary tightening. She called the uptick in the consumer-price index, which is running above the Fed's 2% inflation target (admittedly using a different gauge, the personal consumption deflator), "noisy." But it's hurting Americans' budgets more than their ears.
In essence, Yellen endorsed the view espoused by hedge fund mogul David Tepper a couple of years ago, that the course of monetary policy "depends" on the economy. If growth is sluggish, policy will remain accommodative, which is bullish for risk assets. Interest-rate hikes won't come until there is strong growth, which also is bullish. And as long as the monetary authorities have their back, investors have little reason to worry. So, volatility premiums collapsed in the options market; if the Fed is offering free insurance, why pay for it with hedges?
This benign environment is spurring investors to vote with their portfolios. Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, notes a big, $13 billion inflow into equity mutual funds in the latest week and the first outflows from bond funds, totaling $2.3 billion, in 15 weeks.
Have fund investors finally been infused with animal spirits? Hard to say, given that the equities data showed a record influx into utilities, some $1.2 billion, which Hartnett suggests indicates some chasing of that group's torrid past performance, up some 16% in 2014. Utility stocks are viewed as first cousins to bonds; income is their primary allure, but with the prospect of dividend growth, that should trump fixed coupons.
Still, public participation in the stock market has yet to evince irrational exuberance, notes David Rosenberg of Gluskin-Sheff. In other words, the market has yet to violate rule No. 5 of Bob Farrell, the legendary market analyst at Merrill Lynch -- that the public buys most at the peak and least at the lows.
Tops, Rosenberg explains, typically show a melt-up of a heady 11% over 30 days, which represents a first peak. A pullback lures neophytes and momentum chasers "hook, line, and sinker," to form twin peaks. That pattern was apparent in November 1980; August-October 1987; June-July 1990; April-September 2000; and July-October 2007, he points out.
To quote every parent of young kids, we're not there yet. But, Rosenberg relates, there also is Farrell's rule No. 7: Markets are strongest when they are broad and weakest when they narrow to a handful of blue chips.
Another veteran market maven, John Mendelson of International Strategy & Investment Group, last week pointed to the declining number of New York Stock Exchange stocks trading below their 200-day moving averages, a sign of waning momentum in the broad market that he says represents a "negative divergence." That is especially so with the major averages notching records.
So, easy money continues to float Wall Street's yachts. Belatedly, the gold market also has noticed, with the metal surging 3% on the week, and mining stocks leading the advance. Gold may be sending the true signal, above the supposed noise from the inflation indexes.
33 ETF With P/Es Below 10 Yes, I'm also keeping my eye on GVAL. Especially after reading Mebane Faber's book Global Value. Also keeping my eye on CAPE and DSENX
Doubleline Shiller Enhanced Cape DSENX There is a related exchange traded note, symbol CAPE.
Not a Doubleline product, but deserves comparison to the DSENX.
Both deserve study, as the Shiller CAPE ratio is being talked about more and more each day.
