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How Your Bond Mutual Fund Could Face Liquidity Risk—and Why

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Corporate bond ownership

According to research by Tobias Adrian, Michael Fleming, Or Shachar, and Erik Vogt of the Federal Reserve Bank of New York, mutual funds currently own over 20% of outstanding corporate bonds, compared to ~4% in 1990. This trend has gained traction since 2010.

More importantly, this trend shows that mutual funds, specifically bond mutual funds, have a bigger role in credit intermediation, especially since the financial crisis of 2008. By using the term “credit intermediation,” we broadly imply that bond mutual funds have become a large source of providing liquidity to the market due to their large holding of corporate bonds.

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Declining dealer roles

The group’s research report, under the title “Redemption Risk of Bond Mutual Funds and Dealer Positioning,” shows that the broker-dealers’ ownership of corporate bonds, in contrast to mutual funds, has declined sharply. They owned an average 2.6% of the outstanding corporate bonds from 1990–2009. But the average stands at 1.3% between 2010 and October 2015.

What it means

Previously in this series we talked about how broker-dealers act as market makers—entities that provide channels for you to buy and sell when you want. But since their ownership of corporate bonds has declined over the years, there are now fears that if the corporate bond market and related vehicles were to witness selling pressure, broker-dealers would be unable to absorb it.

You’d think that, since mutual funds own about a fifth of outstanding corporate bonds, they’d be able to provide liquidity. But this is precisely where the concern lies for investors in bond mutual funds.

Why it matters

Say, for example, that if yields were to rise sharply. Bond mutual funds would consequently face severe redemption pressure. This, in turn, would force funds to sell their holdings, and selling across the board would cause sharp declines in prices—especially for illiquid bonds.

But let’s follow this further. With everyone selling—and with mutual funds having a large share of corporate bonds—who would be a willing buyer? Even worse, if bond market funds can’t sell due to a shortage of buyers, fund houses would be stuck with bonds witnessing unreasonably low prices—a liquidity crisis.

Theoretically, liquidity risk is assumed to be higher for junk bonds (PAHIX) (COMM) (MT) than for investment-grade bonds (FPCIX) (KEY) (NI). But amid fierce redemption pressure, relatively illiquid investment-grade bonds would see a very sharp drop in prices as well.

A break-up of total net assets in money market mutual funds in the above graph shows that 57% of the assets are invested in prime or corporate debt funds—a figure that has remained nearly unchanged over the past two months. What should bond mutual fund investors do with their investments?

Continue to the next and final part of this series for a look at what investors in bond mutual funds can do during a liquidity squeeze.

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