Contagion from Liquidity Crunch at Junk-Bond Funds to Trigger “Material Second Round Effects”: EU Securities Regulator

Contagion from Liquidity Crunch at Junk-Bond Funds to Trigger “Material Second Round Effects”: EU Securities Regulator

The costs of dodging negative interest rates.

By Nick Corbishley, for WOLF STREET:

In the event of a market shock, 40% of European funds focused on junk-rated bonds — ironically named “high-yield” funds — would not have enough liquid assets on hand to meet investor withdrawals, even if the withdrawals in one week amount to only 10% of the fund’s net asset value, the European Securities and Markets Authority (ESMA) warned this week, raising yet more concerns about the risks associated with the liquidity mismatch at funds that offer daily redemptions while holding illiquid assets that can take much longer to sell at survivable prices.

In the wake of liquidity problems at H2O Asset Management and the recently gated £3.7 billion Woodford Equity Income Fund, two UK-based firms that remain under ESMA authority until (or unless) the UK leaves the European Union, central banks and financial regulators have issued a string of warnings about the liquidity risks posed by open-ended funds.

Bank of England governor Mark Carney caused consternation in the fund industry by saying that open-ended funds like Woodford’s are “built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid.” They could even pose a systemic risk, the Bank of England warned in July. Similar concerns have been raised in recent weeks by the European Systemic Risk Board, the Bank for International Settlements, the International Monetary Fund and the G20’s Financial Stability Board.

Now, it’s the turn of Europe’s top securities regulator to sound the alarm. As part of what it calls a “pure redemption shock simulation,” the regulator examined roughly 6,600 bond funds that were set up under UCITS (Undertakings for the Collective Investment in Transferable Securities), the EU regulatory framework for mutual funds. These UCITS funds had an aggregate net asset value (NAV) of €2.5 trillion. ESMA wanted to determine how these funds would cope if investors demanded redemptions worth the equivalent of 10% of a fund’s value in a week.

What ESMA found was that while the majority of funds would have sufficient liquid assets on hand to meet investors’ redemption requests, there were “pockets of vulnerabilities,” especially among “high-yield” (HY) bond funds and emerging-market (EM) bond funds.

“In particular, UCITS offering daily redemptions to investors while investing in less liquid assets such as HY or EM bonds might be subject to a liquidity mismatch,” the authors note. “HY and EM fund flows tend to be more volatile than other fund styles,” having experienced large outflows during the global financial crisis, as well as during the taper tantrum in mid-2013.

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Wolf Richter

In his cynical, tongue-in-cheek manner, he muses on WOLF STREET about economic, business, and financial issues, Wall Street shenanigans, complex entanglements, and other things, debacles, and opportunities that catch his eye in the US, Europe, Japan, and occasionally China. WOLF STREET is the successor to his first platform… TP-Title-7-small-200px …whose ghastly name he finally abandoned in July 2014. Here’s the story on that. Wolf lives in San Francisco. He has over twenty years of C-level operations experience, including turnarounds and a VC-funded startup. He earned his BA and MBA in Texas and his MA in Oklahoma, worked in both states for years, including a decade as General Manager and COO of a large Ford dealership and its subsidiaries. But one day, he quit and went to France for seven weeks to open himself up to new possibilities, which degenerated into a life-altering three-year journey across 100 countries on all continents, much of it overland. And it almost swallowed him up.