New York Times article on bond funds

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Bustoff
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New York Times article on bond funds

Post by Bustoff » Sun Apr 12, 2015 7:53 am

Yesterday, the NYT published an article titled, Questioning the Seaworthiness of Bond Funds, written by Diana B. Henriques.

While the article is not hyperbolic in nature, it's difficult to tell if any of this should be a source of concern because the subject of the article deals with somewhat esoteric aspects of the bond market.

The author has written extensively about financial issues and regulation. http://dianabhenriques.com/bio/
Last edited by Bustoff on Sun Apr 12, 2015 8:07 am, edited 2 times in total.

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Re: New York Times article on bond funds

Post by simplesimon » Sun Apr 12, 2015 7:55 am


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Bustoff
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Re: New York Times article on bond funds

Post by Bustoff » Sun Apr 12, 2015 8:10 am

simplesimon wrote:Article linked here: http://www.nytimes.com/2015/04/12/busin ... funds.html
Thanks simon. I went back and fixed the omission.

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Re: New York Times article on bond funds

Post by livesoft » Sun Apr 12, 2015 8:16 am

It would be interesting to see what the average daily volume is in the "primary market" (where authorized participants exchange the ETF shares with the underlying bonds) for the most popular bond ETFs (and the ones I own :) ). Is that info readily available and is it available for every day?
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Re: New York Times article on bond funds

Post by Aptenodytes » Sun Apr 12, 2015 8:49 am

livesoft wrote:It would be interesting to see what the average daily volume is in the "primary market" (where authorized participants exchange the ETF shares with the underlying bonds) for the most popular bond ETFs (and the ones I own :) ). Is that info readily available and is it available for every day?
The author implies that that information is available but doesn't give details on how to get it. Very low information density in this piece. Reporters have no time to report any more so they fill column inches with fluff.

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Re: New York Times article on bond funds

Post by midareff » Sun Apr 12, 2015 9:02 am

OTOH how worried should I be about the liquidity of a fund or ETF I am not going to sell?

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Bustoff
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Re: New York Times article on bond funds

Post by Bustoff » Sun Apr 12, 2015 9:15 am

livesoft wrote:It would be interesting to see what the average daily volume is in the "primary market" (where authorized participants exchange the ETF shares with the underlying bonds) for the most popular bond ETFs (and the ones I own :) ). Is that info readily available and is it available for every day?
Good question. This article shows "primary market" Trading Activity in Bond ETFs, January–April 2013 and May–July 2013.
http://www.ici.org/viewpoints/ci.view_1 ... dity.print

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Re: New York Times article on bond funds

Post by Aptenodytes » Sun Apr 12, 2015 9:17 am

midareff wrote:OTOH how worried should I be about the liquidity of a fund or ETF I am not going to sell?
The concern is that structural problems arising from the liquidity artifacts will trigger broader panic and price volatility. Some funds may encounter significant costs if they have to borrow heavily to meet redemption needs. Perhaps you still don't care because you have confidence that the prices will equilibrate just fine once the panic ebbs. The article quotes one person who I think says basically that.

That said, the article is skimpy on the precise logic relating the structural conditions to investor risk. Most of the argument, to the extent there is an argument at all, is via insinuation. You might say that's OK because the nature of panics is that they are unpredictable and lead to unpredictable things, so just knowing that there's a risk of panic is newsworthy.

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Re: New York Times article on bond funds

Post by nisiprius » Sun Apr 12, 2015 9:37 am

midareff wrote:OTOH how worried should I be about the liquidity of a fund or ETF I am not going to sell?
You could theoretically have reason to worry if situations arose that created the equivalent of a "run" on a bond fund.

Before continuing I note that the cure, of course, is to pay attention to the liquidity of the underlying issues in the bond funds or ETFs one holds. In this regard, a lot of handwringing (by John C. Bogle, among others) about the Barclay's Aggregate Index, and thus Vanguard Total Bond, for being "too heavy" in government issues (thus not taking enough risk and not getting enough return), should be offset by the fact that government issues are highly liquid.

Rick Ferri's 2013 piece on Solving The Bond ETF Discount Problem uses "high-yield" bond funds as the illustration. High-yield bonds, emerging markets bonds, even corporate bonds--seem to have at least some liquidity issues.

The issue of bond fund liquidity is serious enough for both the SEC and the IMF to have floated trial balloons suggesting that there should be a redemption fee to discourage precipitous redemptions from bond funds.

With mutual funds, the problem is that the fund determines an end-of-day NAV and is pledged to redeem at that NAV. We are used to thinking of liquid securities with an accurate "market price"--we can sell any time we choose and get something close to the posted "market price." For less-liquid securities, though, the NAV is more in the nature of a guess. If the bond market dried up suddenly at the same time as there was a rush of redemptions, a fund might discover that there was no market for the bonds to which it had assigned a NAV of $1,000. It would be committed to paying $1,000 to people making redemptions, but might need to sell a disproportionate share of its bond portfolio because it might not be able to get anything close to $1,000 for them. Normally, any such errors would be small (and might occur in both directions), could be corrected the next day, and could be met from the cushion of cash held to meet redemptions. However, if the fund's shareholders came to believe that the fund's total NAV was $1 billion but the true value of the bonds in the fund was much less than that, that would create the conditions for a disorderly "run" on the fund. The people redeeming first would make out much better than people redeeming later.

If you think it through, the nightmare for the individual buy-and-hold investor is that the math may suggest that their $10,000 holding represents, let's say, the equivalent of ten bonds--but theoretically if enough early birds demand redemption and the bonds can't be sold for anything close to their NAV, the early birds could gain at the expense of the others--in order to meet the redemptions, the fund might have to sell a disproportionate amount of their holdings, and the people who didn't join in the run would find at the end of it that their $10,000 holding has not only fallen in value to $9,000 but that it only represents nine bonds.

My knowledge isn't extensive, but I've never heard of such a thing happening in a bond mutual fund. But it's theoretically possible--it's one of the situations the Investment Company Act of 1940 was intented to prevent--and it's what the redemption fees suggested by the SEC and IMF are intended to prevent. It is essentially what actually happened to the Reserve Primary money market fund.

The normal behavior of mutual funds depends on the idea that the assets in the fund are reasonably liquid and have a market value that can be estimated reasonably accurately. The less liquid the assets and the more guesswork in the NAV, the greater the possibility of some kind of problem. In ordinary times, the investor is insulated from this by the pledge to redeem at NAV. You say "well, the mutual fund promises to redeem at this net asset value, and if that value is wrong it's their problem, not mine." But if it gets bad enough it could theoretically become the fund shareholders' problem.

The important thing about bonds in a portfolio is that they be relatively low in risk, not that they be classified as "bonds."
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Re: New York Times article on bond funds

Post by Bustoff » Sun Apr 12, 2015 9:49 am

Aptenodytes wrote: The concern is that structural problems arising from the liquidity artifacts will trigger broader panic and price volatility.
Isn't it the opposite?
My impression was that, yes, there are real liquidity issues, but it's not the "liquidity issues" that could trigger a panic. Rather, it will be panicky redemptions in the secondary market that will start the chain reaction.

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Re: New York Times article on bond funds

Post by Aptenodytes » Sun Apr 12, 2015 10:09 am

Bustoff wrote:
Aptenodytes wrote: The concern is that structural problems arising from the liquidity artifacts will trigger broader panic and price volatility.
Isn't it the opposite?
My impression was that, yes, there are real liquidity issues, but it's not the "liquidity issues" that could trigger a panic. Rather, it will be panicky redemptions in the secondary market that will start the chain reaction.
I'm getting out of my element here, but isn't it the liquidity fears that trigger the panicky redemptions? Liquidity problems during price shocks are not good for stability no matter where they are located.

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Re: New York Times article on bond funds

Post by Louis Winthorpe III » Sun Apr 12, 2015 10:23 am

Liquidity problems would lead to higher volatility. People buy bonds and bond funds mainly because they have low volatility. It strikes me as a concern, but I don't know how to assess whether it's a big deal or a little deal.

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Re: New York Times article on bond funds

Post by livesoft » Sun Apr 12, 2015 10:30 am

Bustoff wrote:
livesoft wrote:It would be interesting to see what the average daily volume is in the "primary market" (where authorized participants exchange the ETF shares with the underlying bonds) for the most popular bond ETFs (and the ones I own :) ). Is that info readily available and is it available for every day?
Good question. This article shows "primary market" Trading Activity in Bond ETFs, January–April 2013 and May–July 2013.
http://www.ici.org/viewpoints/ci.view_1 ... dity.print
Thanks for finding this. It seems that the primary market on average is about 18% of the secondary market for those times. That is higher than I thought.
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Re: New York Times article on bond funds

Post by nisiprius » Sun Apr 12, 2015 11:14 am

I mentioned concern by the SEC and the IMF in my earlier post, here are some sources:

CNBC, 16 Jun 2014: Fed looks at exit fees on bond funds
Federal Reserve officials have discussed whether regulators should impose exit fees on bond funds to avert a potential run by investors, underlining concern about the vulnerability of the $10 trillion corporate bond market.

Officials are concerned 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. The Fed discussions have taken place at a senior level but have not yet developed into formal policy, according to people familiar with the matter.

"So much activity in open-end corporate bond and loan funds is a little bit bank like, "Jeremy Stein, a Fed governor from 2012-14 told the Financial Times last month, just before he stepped down. "It may be the essence of shadow banking is ... giving people a liquid claim on illiquid assets."
Bloomberg, "Oct. 22" (of 2014... I think) IMF Finds Flaw in Bond Industry as Exiting Funds Too Easy
Investment firms made it easy for individuals to plow into infrequently-traded debt in good times. Perhaps they should make it tougher to exit in downturns.

That’s how analysts at the International Monetary Fund see it anyway. They say regulators should consider new policies to prevent a mass exodus from funds that own illiquid debt.

The concern is that investors in mutual funds and exchange-traded funds have become complacent because they can trade fund shares daily, even though their money has been locked up in assets such as high-yield bonds and loans. Trades in those markets can take weeks to complete.

“This mismatch between the liquidity promised to fund owners in good times and the cost of illiquidity when meeting redemptions in periods of stress is a concern and call for action by regulators,” Fabio Cortes, an economist in the IMF’s monetary and capital markets department, wrote in an e-mail this week...
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Re: New York Times article on bond funds

Post by kolea » Sun Apr 12, 2015 11:32 am

Thanks nisiprius. I always learn a lot from your posts. Very clearly written.
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Re: New York Times article on bond funds

Post by ogd » Sun Apr 12, 2015 1:14 pm

It's important to distinguish between two different issues (or "perspectives") related to bond liquidity here.

1) is too much price volatility when liquidity dries up, because assets will be sold at haphazard prices instead of the orderly decline one might expect. This is what most of the article and Rick Ferri's article are talking about, and it's a bigger concern with many bond ETFs because of the construction and price mechanisms. This one is important to you if you expect your bonds to be liquid at all times; presumably, it's far more important to institutional investors than to non-leveraged individuals.

2) is losses to long-term shareholders because of mismatches between NAV and the prices of actual sales; specifically, the NAV could be too high compared to the money received from sales, meaning the outgoing shareholders are taking too much money out of the fund. This is what nisiprius is talking about. In the Reserve Primary example the NAV was too high by construction so it was inviting this sort of problem.

Regulators and institutions are more concerned about #1 than we should be. They don't like flash crashes and they don't like overly volatile pricing that can mess with margin accounts or reserve requirements. If you're a long-term investor, on the other hand, you mostly care about #2.

So, how worried should you be? The complete lack of examples of large, well-constructed funds (e.g. funds that didn't pretend their shares were worth $1 at all times) losing money to liquidity tells me, "not very". Furthermore, I like that the Vanguard funds I invest in have my interests in mind first and foremost, as opposed to trying to not look volatile for marketing reasons. And they do have a last-resort option, which is to force redemptions in-kind making the accuracy of the NAV irrelevant. I also like that regulators are looking at ways to improve the transparency of bond trades for better prices, even though they're doing this for reasons mostly different than mine.

There are also things you can do as an investor to address this. One of these is, interestingly enough, where the above distinction comes in: by construction, bond ETFs do all redemptions in-kind so long-term shareholders are insulated from the (potentially terrible) liquidity costs that the outgoing shareholders are forced to pay, on the terms of the ETF market makers. You'd better not be one of those sellers, though.

Another is to stick to liquid bonds like Treasuries and investment grade. All that's needed for mutual funds to work well is good pricing -- we note that in the world of stocks both volatility and investor flight are immensely higher, yet there's no problem with flight affecting shareholders that don't sell, e.g. in 2008. Yet another is to be in the large, sedate, diversified Vanguard funds that don't see much flight compared to assets and might even see the opposite move from rebalancing often enough; at the very least, their huge inventory of bonds should make it easy to find something to sell at reasonably accurate prices at all times.

So what about #1? This one does suggest, like Rick says, to stay away from bond ETFs if you want to be able to sell whenever. When the article talks about how 2013 went well for those, I wouldn't necessarily agree -- the 5% or so discounts I was seeing in some (thin) muni ETFs are nothing to sneeze at. On the other hand, if you are ready to buy the (scary-looking) ETFs at such times and hold until liquidity improves, you can make quite a bit of coin. I wonder if the profits that were on the table for those few short weeks raised other eyebrows as well and more hedge fund attention could be diverted to making money from providing bond ETF liquidity, the next time around.

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Re: New York Times article on bond funds

Post by nisiprius » Sun Apr 12, 2015 5:57 pm

Thanks for your insightful comment, ogd.
And they do have a last-resort option, which is to force redemptions in-kind making the accuracy of the NAV irrelevant.
A well-informed correspondent told me that as far as he knows redemptions in kind have only occurred when the fund shareholder was a) a large institutional investor who b) wanted redemption in kind. But the option is in there, and it would seem that it could be used as an escape hatch.
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Re: New York Times article on bond funds

Post by snowshoes » Sun Apr 12, 2015 6:23 pm

TwoByFour wrote:Thanks nisiprius. I always learn a lot from your posts. Very clearly written.
+1 :wink: :thumbsup

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Re: New York Times article on bond funds

Post by ogd » Sun Apr 12, 2015 7:37 pm

nisiprius wrote: And they do have a last-resort option, which is to force redemptions in-kind making the accuracy of the NAV irrelevant.
A well-informed correspondent told me that as far as he knows redemptions in kind have only occurred when the fund shareholder was a) a large institutional investor who b) wanted redemption in kind. But the option is in there, and it would seem that it could be used as an escape hatch.
Thanks, nisiprius.

It was probably never needed. The funds do have many other ways to manage liquidity, including derivatives and selecting securities which can be sold favorably, before this last resort.

The wording in the prospectus does not merely say that you can do this -- it's specifically about redemption in-kind being forced upon you. I hope it's not needed going forward either, but it's nice to know the option (for Vanguard) exists.

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Re: New York Times article on bond funds

Post by grabiner » Sun Apr 12, 2015 11:03 pm

nisiprius wrote:Thanks for your insightful comment, ogd.
And they do have a last-resort option, which is to force redemptions in-kind making the accuracy of the NAV irrelevant.
A well-informed correspondent told me that as far as he knows redemptions in kind have only occurred when the fund shareholder was a) a large institutional investor who b) wanted redemption in kind. But the option is in there, and it would seem that it could be used as an escape hatch.
I believe Vanguard did some redemptions in-kind for Tax-Managed Small-Cap, in order to avoid realizing capital gains on the redeemed shares. This may have been done with the consent of the shareholder.
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Re: New York Times article on bond funds

Post by yosef » Mon Apr 13, 2015 8:53 am

Can someone give a layman's explanation of in-kind redemptions?

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Re: New York Times article on bond funds

Post by Boglegrappler » Mon Apr 13, 2015 9:05 am

An in-kind redemption would give redeeming people their proportionate share of the underlying securities, rather than selling those securities and sending the cash. It has a number of logistical type issues in doing it, but it sidesteps the issue of what things are actually worth. Its not practical to do in most situations.

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Re: New York Times article on bond funds

Post by nisiprius » Mon Apr 13, 2015 9:21 am

yosef wrote:Can someone give a layman's explanation of in-kind redemptions?
With a stock or an ETF you are actually selling shares. With a mutual fund you don't actually "sell" shares of a mutual fund, you "redeem" them (even though everything on the website says "sell.")

Let's pretend a mutual fund had only two holdings (don't think they'd be allowed to hold so few but let's pretend), two stocks, A and B. You tell Vanguard you want to sell it all and press the "sell" button. At the end of the day, Vanguard sees that the price of the stocks is $50 for A and $100 for B, and that your proportional share of the fund holdings is equivalent to 100 shares of each. Vanguard determines that the end-of-day value of your account is $15,000.

They immediately make an accounting entry in your account so that next day when you look online you don't own any shares of the fund any more, and you do have $15,000 coming to you. You don't get the $15,000 instantly. You have to wait until the account "settles." Vanguard owes you $15,000 and they get it from anywhere convenient. Perhaps they get it out of the cash they hold to meet redemptions, and then replenish the redemption cash by actually selling the shares. They might find that they don't get exactly $15,000.00 for those shares but it all evens out and they have this redemption cash buffer.

The reason it's a "redemption" is that the mutual fund company is an intermediary. You aren't selling your shares of the mutual fund to some other investor. The mutual fund company is paying out, out of its own funds, an estimate of what the value of your mutual shares ought to be--based on the market or estimate value of the fund's holding.

The point is, within a few days you get money, actual cash money that you can move out of Vanguard and into your bank account if you like.

"Redemption in kind" would mean that instead of getting money, you receive 100 shares of stock A and 100 shares of stock B.

Conceptually, you are expecting to get a check for $15,000 in the mail, and instead, when you open the envelope, you find two stock certificates inside.

On the one hand, this seems sort of fair because that's your actual share of the fund's assets. On the other hand, it seems unfair because the reason something like this would happen would be that they said the stocks were worth $15,000 at the end of the day when you redeemed them, but really it turned out they were worth less than that.

I don't think this has ever really happened to retail investors. I have no idea whether it really could. My layman's reading of fund rules suggests that they do have the right to do it if necessary. As with many things, even if they had the right, if they actually did this, it would make headlines and rattle retail investors so badly that they'd need to be awfully desperate to do it.
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Re: New York Times article on bond funds

Post by yosef » Mon Apr 13, 2015 9:41 am

Thanks for the explanation. I can definitely see how such a move would not be well received by individual investors.

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Re: New York Times article on bond funds

Post by Bustoff » Tue Apr 14, 2015 7:36 am

ogd and nisi -
Thank you very much.

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