Bill Gross is worried about bond market liquidity.
In the last several months, bond market liquidity is probably the biggest meme that has permeated markets.
But it seems that we are not done — yet! — worrying about bond market liquidity.
In his latest investment outlook published on Tuesday, Janus Capital’s Bill Gross writes:
“[C]urrent concerns in the financial markets center around the absence of liquidity and the effect it might have on future market prices. In 2008/2009, markets experienced not only a Minsky moment but a liquidity implosion, as levered investors were forced to delever. Ultimately the purge threatened even the safest and most liquid of investments. Several money market funds appeared to ‘break the buck’ which in turn threatened the $US4 trillion overnight repo market — the center core of our current finance-based economy.”
Gross then walks through what has now become received wisdom on bond market liquidity.
Post-financial market regulations (read: Dodd-Frank) have required banks and other “systemically important financial institutions” to hold more cash on their balance sheet, creating less bond inventory on balance sheets — fewer potential buyers, fewer potential sellers — if portfolio managers are forced to meet client redemptions quickly and en masse.
But Gross adds a new wrinkle. He argues that firms like the one he co-founded — PIMCO — as well as other large asset managers like BlackRock, now present the systemic risk that Dodd-Frank sought to transfer away from banks.
Gross writes that these firms, “are part of the ‘shadow banking system’ where these modern ‘banks’ are not required to maintain reserves or even emergency levels of cash.”
But shadow banking structures — unlike cash securities — require counterparty relationships that require more and more margin if prices should decline. That is why PIMCO’s safe haven claim of their use of derivatives is so counterintuitive. While private equity and hedge funds have built-in “gates” to prevent an overnight exit, mutual funds and ETFs do not. That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances. But even in milder “left tail scenarios” it is price that makes the difference to mutual fund and ETF holders alike, and when liquidity is scarce, prices usually go down not up, given a Minsky moment. Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers’ hands are tied to perform their historical function of buyer of last resort. It’s then that liquidity will be tested.
And so we quote Gross at length because he’s making an important point.
By shifting the risks away from banks and to asset managers, Gross argues that the risk of herd behaviour that causes a liquidity event in markets has been shifted away from the professional investing class and to a more amateur, less-informed, skittish class of investor: the public.
And the way these firms have managed to address potential liquidity concerns — by using derivatives — inherently increases the number one thing that concerns Gross when looking at market structure: leverage.
Leverage is a great tool for amplifying returns, but can also amplify losses. And this is what Gross doesn’t like, writing, “The fact is that derivatives on a systemic basis represent increased leverage and therefore increased risk — presenting possible exit and liquidity problems in future months and years.”
As for what investors should do? Gross says hold cash.
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