Banks May Be Safer in a Debt Crisis, But Investors Aren’t

Regulators are worried about what happens in bond markets when institutional investors face a liquidity crunch

By Paul J. Davies

Get ready for a rocky ride in bond markets. The price of a safer banking system is more danger for investment institutions. 
U.S. and U.K. regulators last week sounded warnings about the knock-on effects for corporate debt markets when large institutional investors face demands for liquidity. These demands could cause more turmoil than in the past because investors now provide much more corporate funding and are more exposed to collateral calls from derivatives.
One element of this is leverage: The U.S. Federal Reserve in its debut Financial Stability Report and the Bank of England in its regular one both noted a recent rise in borrowing by hedge funds. Separately, the Fed noted that lending commitments by large banks to nonbank financial firms rose to nearly $1 trillion by the middle of this year, from less than $600 billion five years ago. Most of the growth went to closed-end investment and mutual funds, real-estate investment trusts and special purpose vehicles.

The Fed is also concerned about the potential for runs from open-ended mutual funds. A drop in corporate debt prices could prompt a rush to redeem funds, sparking further falls and so on.

The Bank of England focused on the risk to asset managers, insurers and pension funds from greater demands for liquidity linked to derivatives used to boost returns or hedge exposures. Big moves against an investor’s derivative positions force it to put up more collateral, usually cash. If firms don’t have the cash, they may have to sell other assets, such as corporate bonds. This too could spark a vicious spiral of falling prices, institutions unloading assets and investors redeeming funds, the Bank said.

The Fed is concerned about the potential for runs from open-ended mutual funds. Photo: Andrew Harnik/Associated Press 

Nonbanks have become much more important providers of credit to companies and individuals since the financial crisis as a result of stiffer regulations and higher capital requirements for banks. The Fed noted that mutual fund holdings of corporate debt had grown to about $2.3 trillion in September this year, from more than $500 billion at the end of 2009 in 2018 dollars.

Another debt crisis is less likely to threaten the financial system’s survival because banks are less exposed. But the flip side is that end investors will suffer more losses directly.

Also, banks are less able to cushion price falls. They used to soak up sales with substantial holdings of temporary inventory, but this is no longer possible. So even as investor holdings of corporate bonds have grown bigger, the exit doors have got smaller.

Institutional investors who are sensitive to market values—either because of their own leverage or because their clients panic—are likely to make market routs worse. And as the Fed noted, routs seem more likely with business borrowing at historically high levels and valuations of corporate bonds and loans also high.

Banks may now be safer, but investors aren’t.

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