Fixed-income investors may think rising interest rates are their biggest worry. But bond funds face a new risk, driven by their need for liquidity to service investors’ daily redemptions, according to Michael Aronstein.
Since the financial crisis, fixed-income assets have swollen to $38 trillion and are now nearly three times the market capitalization of the equity markets, according to Aronstein. Under the Dodd-Frank law, banks have been under pressure to “de-risk,” he said, and the only fixed-income assets they hold are high-quality Treasury bonds.
As a result of banks’ de-risking, mutual-fund investors have upped their risk and now own lower-quality debt. Funds have accumulated emerging-market and lower-grade corporate bonds, according to Aronstein.
“The risk has been transferred to the mutual fund industry,” he said.
Bond funds must confront a liquidity mismatch. They advertise daily liquidity, but the underlying instruments that they own “do not have daily liquidity or anything like it, at least not at prices that are near the prices that they carry,” Aronstein said.
Aronstein is president and chief executive officer of Marketfield Asset Management LLC and portfolio manager of the Marketfield Fund (MFLDX). He spoke Sept. 19 at a dinner in Dallas, sponsored by Sincere & Co. and held in conjunction with Bob Veres’ Insider Forum.
Aronstein recalled similar crises – the failures of Bear Stearns’ collateralized debt obligation in 2007 and auction-rate preferreds in 2008 – that were painfully familiar to the advisors in the audience.
“Those weren't random acts like meteorites were falling on firms.” In all cases, the crisis was driven by illiquidity, Aronstein said.
Blame the Fed
Today’s situation was predictable in the aftermath of the financial crisis. Aronstein placed much of the blame on the Fed.
Beginning in 2008, investors understandably gravitated toward safer and less volatile assets as the world went through what Aronstein called a “depression.”
Now, he said, most investors’ portfolios are too biased toward what they think are safe assets. Investors prefer illiquid assets, like bonds. Aronstein said they are paying a premium for that safety relative to what other assets with similar or better risk-and-return characteristics would cost.
“This has resulted in a very unhealthy aversion to market volatility,” he said, “which has kept people from the asset types that have been fundamentally cheaper.”
Aronstein traced the Fed actions over the course of the last five years. He said that the Fed’s rapid balance-sheet expansion, beginning in late 2008, was the proper policy response to an unstable financial system.
But it brought about a fear of hyperinflation from investors. Aronstein said that was the correct reaction, but the actual crisis takes a lot of time to work its way through the system. A similar phenomenon occurred in 2003, when investors prematurely shorted the housing market.
Investors should be guided by an unfailing principle, according to Aronstein: The Fed is always wrong. “The way in which they are wrong is they are slow,” he said of the Fed decision-makers. “They don’t react to data.”
Investing is like playing “Wheel of Fortune,” he said. The goal is to guess the word with the fewest number of letters exposed or, in the case of the markets, to invest correctly with the least amount of data available. The more words – or market data – you need, the more you pay. Because the Fed’s decision-making process requires reaching a consensus among a broad team of economists, it needs a lot more data than the market does.
“By the time they've got enough data to decide that whatever mode they are in is appropriate,” he said, “the market has already way down the road.” The Fed’s delayed responses exaggerate changes in the market, he said.
Stronger economic growth – and not the Fed’s tapering of its quantitative easing (QE) policy – was responsible for the increase in interest rates that began in May, according to Aronstein.
The Fed is now failing to react to the “threat of prosperity,” according to Aronstein. Although the GDP data are underwhelming, Aronstein said corporations are reporting strong profits and healthy balance sheets, households are delevering, the housing market has improved and real wages are growing. Only the contraction of federal and state governments is preventing a more robust recovery.
By “staying too easy too long,” Aronstein said the Fed allowed the issuance of bonds that never should have come to the market over the last two years. He said the initial public offering calendar over that period “dwarfed anything that happened in 1999 or 2000.” The JOBS act may have contributed to the increase in IPOs, but Aronstein did not mention that.
Finding a safe haven
Signs of a liquidity crisis started to appear in June in the municipal-bond market, according to Aronstein, when bid-ask spreads hit five points in the broker-dealer community.
“This is one of those circumstances where all the elements that we look for as being potentially a source of irreparable risk are starting to happen,” he said.
If a crisis erupts in the Middle East, India or Europe, Aronstein doesn’t expect it to drive rates markedly lower. Compared to five years ago, investors are now more inured to the risks in the global economy and capable of absorbing the shock such a crisis would produce.
“The thing I worry about is you get a bunch of mutual funds they can't redeem,” Aronstein said. “It could be some obscure bond fund that is trying to push its yield and return because it needs to perform and raise more money.”
“Making money by managing bonds and the cumulating assets under management in fixed-income products has been a very good business,” he said. Indeed, Aronstein said it’s very hard not to compete for a few extra basis points.
Risk is amplified by funds that are measured against a benchmark. For those managers, the incentives to outperform their peers can cause them to make decisions that are not prudent for investors, according to Aronstein. Managers must put money to work if the benchmark moves in a certain way, even if viable investment opportunities are not present.
What will trigger a liquidity crisis in bond funds? Aronstein said it could be an unexpected piece of data or a rumor about a fund in distress. But the underlying structural elements that precipitate such a crisis are in place. Aronstein said it is like a concrete column that is crumbling. “You don't know if something is going to happen in a week, but you know at some point it will,” he said. “You know just how it's going to proceed and why it will fail.”
Funds that have sustained investor demand by creating structures that use derivatives and synthetic instruments further demonstrate structural weakness, Aronstein said. Those instruments are less liquid and more vulnerable to a liquidity crunch than their cash counterparts.
Aronstein said investors should “prudently take money out of riskier sectors of the bond market.” He said the downside would be sacrificing 3% to 4% in annual return by moving to high-grade debt. He said equities would go down if a fixed-income crisis hit, but it would not be a permanent impairment of capital.
Excess capital, thrust upon the markets by QE from the world’s central banks, has created a unique situation. “This is the first time in centuries the main problem in the world is there is too much money,” he said.
Aronstein looks for the sector of the market where investors are most vulnerable, he said. In 1989, it was Japan. In 1997 and 1998, it was Asia. It was technology stocks a few years later, and it was housing in 2007. “My fear now is that it is fixed income,” he said.
Read more articles by Robert Huebscher
