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A Fire Drill For Bond Funds

The Securities and Exchange Commission has decided the recent volatile state of the market means it is time to give money managers a pop quiz.

Regulators want to know whether bond mutual funds will be able to meet redemption demands during periods of financial stress, Bloomberg reported. The nature of bond funds means that the SEC’s questions are not baseless, but depending on what the tests reveal, the SEC will need to find a way forward that does not render bond funds useless through overregulation.

The commission’s primary concern is that if the bond market gets seriously rattled by rising interest rates and other fallout of the Federal Reserve unwinding its easy-money policies as planned, it could trigger a situation reminiscent of the autumn of 2008, in which buyers effectively went on strike. Unlike corporate stocks, bond demand could dry up in a very real way. The reason is inherent in the difference between corporate stocks and bonds.

There is a limited pool of publicly listed companies - a few thousand on the major U.S. stock exchanges. At some price, these stocks trade all time, with the exception of tiny penny stocks, which most investors should avoid anyway. So for stock mutual funds, the SEC is not truly worried investors can’t get their money back at all. Stocks can always be liquidated, even if it is at a lower price than a seller wants.

But there are vastly more bonds out there than stocks. There is a greater number of issuers, and each issuer can offer many bonds with many different characteristics. Bonds also typically trade less frequently and in a more opaque market than do stocks. In fact, much of bond trading relies on brokers who act as market makers. Instead of facilitating a transaction between buyer and seller, as stock brokers do, bond brokers often buy bonds from the sellers themselves. The brokers then turn around and sell the bonds to someone else at a price they deem appropriate, historically charging a significant spread between their buy price and sell price. The smaller the investor, the larger the spread, which is one of the advantages for investors to buy their bonds through mutual funds, which can achieve economies of scale and which are sometimes large enough to cut out the brokerage middlemen entirely.

In a normal market, this process works fine. In irregular conditions, though, a broker may not be willing to buy the bond in the first place. This could be because the broker does not believe there are any buyers to be found; or, in the case of major bond funds, the position may be prohibitively large. Either possibility - debt too big to unload readily or a market so disrupted that there are no buyers - worries the SEC.

Other regulators share these concerns. The International Monetary Fund and the Federal Reserve have both considered the risk borne by major bond investors, such as Pimco, that have accumulated large positions in foreign and corporate bonds, which are considered especially hard to sell in a crisis. The untested logic is that there is always a market for U.S. treasuries, which will be true until it isn’t, but for now the SEC and other regulators have mostly confined their worries to more esoteric sorts of debt. What happens to a bond fund that has promised investors a certain level of liquidity if circumstances prevent the fund from readily turning its holdings into cash?

There is nothing wrong with the SEC asking this question. But the question being asked brings up another, which is what the SEC expects mutual funds to do about it. Disclosure of the risks alone is unlikely to satisfy regulators. As we learned from the 2008 financial crisis and its aftermath, regulators are inclined to contend after the fact that disclosures were insufficient. It would be hard, if not impossible, to rely on disclosure alone to protect a bond fund from accusations of irresponsibility and deception, if history is any guide.

It may perhaps prove more effective for mutual funds to strengthen existing provisions that allow funds to suspend redemptions during market turmoil, and concurrently to beef up investor warnings that the next-day liquidity offered by the funds is a goal, not a guarantee. While funds will naturally want to avoid having to trigger such provisions or falling short of this goal, these steps could serve as safeguards to prevent even bigger problems arising in extreme conditions.

Bond funds do have risks, especially because of the relatively illiquid bond market. But investors choose to take on risk in a variety of ways. They should be permitted to knowingly assume the risk that debt instruments, whether held directly or through mutual funds, could lose value and become illiquid, if they wish to do so. But investors - small investors in particular - may lose this option should the rules become so stringent that the funds can no longer function. The SEC previously considered steps that were tantamount to regulating money market funds out of existence completely; it would behoove regulators not to confuse appropriate prudence with taking away investors’ options.

Modern houses are built with sprinkler systems to suppress fire; that is undoubtedly a good thing. But no one could live in a house where the sprinklers ran all the time. The SEC ought to keep that principle in mind.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

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