Wednesday, June 18, 2014

Bond Fund Buyers Beware

Proposed Bond Fund Fee Highlights the Unappreciated Risk in Bond Mutual Funds

Readers of the Financial Times were confronted yesterday with a front-page article headlined, “Fed Fears Over Bond Fund Run.” According to the article, the Federal Reserve, increasingly concerned about the vulnerability of the bond market, particularly bond mutual funds, is considering an unprecedented move to impose exit fees on bond fund owners looking to redeem their shares.

The Financial Times highlights the problem facing the Federal Reserve:

“Officials fear that bond funds are becoming ‘shadow banks’, because investors can withdraw their money on demand, even though the assets held by the funds can be hard to sell in a crisis.”
“. . . U.S. retail investors have pumped more than $1 trillion into bond funds since early 2009. This has created a boom for fixed-income money managers, but raises the prospect of a massive disorganized flight of money should interest rates rise
sharply.”

The goal of the proposed fees is to discourage this mass exodus from the bond market and prevent a bursting of the bond bubble. This is an important acknowledgement of the significant risk that should have been apparent to investors who parked assets in bond funds for their perceived safety. We think the Fed’s fears regarding bond mutual funds, a favorite investment of many wealth management firms looking to safeguard clients’ “sleep-at-night money,” are warranted.

It is important to note the distinction between bond mutual funds and actual individual bonds. Mutual funds that invest in bonds, even the safest bonds, carry a risk that owners of individual bonds avoid. Under normal circumstances, if an investor in the bond fund wants to sell, the manager can use the money from a new investor to pay to seller without selling the underlying bond. However, when there are more sellers than buyers, the fund is forced to sell the bonds to make up the difference. Bond investors are accustomed to the two main risks in this sector: the bond may default and the value may decline if interest rates rise. But a run on bond funds is a particularly acute problem for those invested in them. The bond fund market has ballooned to over $10 trillion with an increasing proportion of those assets from retail investors. A sharp rise in interest rates, which many economists and financial commentators consider a matter of when rather than if, could trigger a panic and a rush of bond fund investors looking to sell. If this run on bond funds happens, fund managers will have to sell, potentially at steep losses, and fund investors will find that the value of their investments was far less secure than they thought. Unlike bond funds though, limiting fixed-income investments to individual bonds, which Marietta advises for clients, gives investors the option to hold the bond to maturity and receive the bond’s par value. Bond mutual funds never mature and during a run its investors are left to the mercy of the market.

While the Fed is concerned about the effect such a sharp rate rise will have on the broader economy, its targeting of bond mutual funds should serve as a warning to bond fund investors. Bond mutual funds carry unique risk in a time of historic, artificially inflated bond prices. Wealth managers who view these investments as secure based on the quality of the bonds in the fund ignore, to the detriment of their clients, the market risk inherent in these investments. Marietta aims to protect clients against the traditional risks of bonds by holding short maturity, high-quality bonds, and we have consistently advised against holding bond funds rather than actual bonds because of the potential illiquidity of the fund shares. That the central bank is even considering such an extraordinary control over the bond fund market reinforces our conviction that bond mutual funds expose investors to heightened and inappropriate risks, especially those investors looking to reduce risk by investing in bonds.

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