Thursday, June 11, 2015

bond fund liquidity

There has been a lot of metaphorical ink spilled over the last year or so about liquidity in the bond market; my understanding is that for most bond issues buying and selling a small quantity incurs roughly the same transaction costs as it did ten years ago, or possibly less, but buying and selling a large quantity is a lot harder and more expensive; no single dealer will take your entire trade without a significant price penalty, and even breaking up your trade and going to multiple dealers is probably not going to get you in and out of your position at the sort of spread that was expected several years ago.  The big concern, though, seems to be with tail risk, namely
  1. at some point in some/many/all important issues, the ability of holders to sell will suddenly disappear altogether, perhaps at a point at which many holders would like to be able to sell
  2. bond funds in particular, which are substantially short a kind of "liquidity risk", will find themselves trying to liquidate a lot of bonds in a hurry in response to a spate of redemptions.
These are obviously tied to each other, and the first (more general) concern should distinguish between the closely related phenomena of "everyone trying to sell at the same time" and "suddenly nobody willing to buy". Microstructure models typically distinguish between "informed" sellers and what are often called "liquidity" sellers, and in an idealized world one might hope that a wave of people selling because they all happen to need cash would be met by a lot of people who don't need cash buying without a large price movement, while one might have substantially less expectation that new investors would buy in response to a wave of selling caused by the expectation of a price drop. In reality, insofar as one of the attractions of a "liquid" investment over an "illiquid" one is that it can become cash if cash is suddenly needed, if the expected value of the effective bid conditional on one's needing cash is low, one doesn't so much care whether that's because the market is thin and transaction costs are high or because one's own need for cash is strongly correlated with fundamental risks underlying the asset — that is to say this distinction is probably important to people trying to understand market dynamics, but may not matter to any individual investor.

Let's talk about bond funds, though.  Like banks, they seem to be intermediating uncomfortably between liquid liabilities and (increasingly) illiquid assets, and this works well (and even creates value) as long as the imbalances between inflows and outflows are small and gradual, but seems susceptible to a run; if I think a lot of other people are going to ask for withdrawals, leading to a heavily discounted sale of assets, I may be inclined to get out first.  It's a little bit softer here, and a little bit more like the fire sale than the bank run in that I probably don't get all of the non-run value if I sell near the beginning of a run and won't lose all of my value if I don't, but it's more like the run than the fire sale in that the fund is probably selling assets on the basis of their liquidity rather than their long-term value, and thus real value is being destroyed instead of being largely reallocated to brave long-term buyers.

One of the arcana I remember learning when I was doing Series 7 back in like 2006 or 2007 is that open-ended mutual fund shares can be transferred, though they usually aren't. "Open-ended" mutual funds are the usual kind — you expect to go to them (perhaps through a broker), given them some new money for them to invest, and get some new shares from them — shares that didn't exist before. Later you take your shares back to them, and they figure out how much they're worth, and they give you cash, and the shares disappear. In principle, unless my memory is wrong or this has changed, you could buy or sell the shares from your cousin Fred at whatever price you and he agreed on (though I'm not sure who the relevant transfer agent would be or how the transfer would otherwise be effected).  I don't know whether there is a prohibition on their being listed on an exchange; certainly it's not usually done, but I don't believe it couldn't be done if a mutual fund company thought served some purpose.

A "closed-end" fund is an idea that has become a lot less popular in the last generation or two, and was a bit more like a traditional stock-issuing company in that it would issue stock in an IPO, invest the proceeds, and return some of the earnings to investors as dividends, while investors bought and sold its stock on an exchange; what distinguished it was only that it would "invest the proceeds" in other publicly traded securities rather than a "real business".  I don't know whether it is allowed to buy or sell its own stock in the secondary market, or under what conditions; presumably it could do a shelf offering, or announce a repurchase, and I think I saw something a month or two ago suggesting that a closed ended fund dedicated to gold had some stated policy of buying back its stock if the price fell too far below the underlying value of the gold.  In practice a lot of closed-ended funds trade at substantial discounts to the assets they own, and sometimes they trade above the value of their assets, and a case could be made for their responding to these deviations by liquidating in a strategic manner and buying back stock when it is below their NAV and selling new shares and investing the proceeds when their stock is above NAV.  In both cases one would expect a soft collar, rather than an absolute peg of the price to the underlying assets, that would take account of transaction costs; in particular, a large drop in the price of the fund shares should lead to sales of liquid assets, but not to a fire sale of illiquid assets; the level of desperation with which assets are sold could be tailored to the extent and persistence of the discount of the fund price to its assets value.

An open-ended mutual fund with listed shares could do something similar from sort of the opposite direction; in particular, it could announce that, if it is faced with a lot of redemption requests, it will start throttling them, liquidating in a responsible fashion over days or weeks but not necessarily by 4PM.  Investors who really need to cash out now can sell at some discount in the market, where more patient investors who trust that the fund will eventually liquidate assets at a decent price will buy the funds shares. (I offered similar idea for bank runs a few years ago.)  Similarly, when a sudden flow of investment leads to the fund's being closed to new investment (as sometimes happens), the more bullish bulls can buy at a premium on the market, and the fund can sell new shares as opportunities to deploy the cash become available.

Either or both of these seem likely to mitigate the liquidity mismatch that bond funds face; if you want to look in the details, I suspect that taxes and management fees (and the associated incentives for increasing assets under management) would be fertile sources of devils.  In principle, when one is looking to sell an illiquid asset, one faces a trade-off between the speed at which the asset can be sold and the price at which it can be sold, and that ideally would match the discount rate of the ultimate investor; how to set up the rules to make that most likely to work out in practice is a question to which the answer is likely to require more care than is the bailiwick of this blog.

It does occur to me, since starting this post, that this is related to my attempted dissertation chapter on shortages and market structure, and should probably even be incorporated into it.