The Fed is sounding the alarm on liquidity risks.
In the Minutes from the January FOMC meeting, the Federal Reserve addressed the financial situation, and noted that the increasing role of bond and loan mutual funds could pose a liquidity risk if everyone tries to get out of the market at the same time.
Here’s the relevant passage, first flagged by Bloomberg’s Matt Boesler:
“Finally, the increased role of bond and loan mutual funds, in conjunction with other factors, may have increased the risk that liquidity pressures could emerge in related markets if investor appetite for such assets wanes.”
And so what the Fed is basically saying here is that because investors are using mutual funds to invest in bonds, instead of owning the bonds, there could be a problem if investors all want to leave at the same time.
When you own a bond mutual fund, you don’t actually own a bond — which will continue to pay a coupon so long as the issuer isn’t in default — you just own a share of the fund, which is comprised of lots of bonds and sometimes other things.
Also, a bond fund is only going to have so much cash on hand, so if the investors in a certain fund all want to redeem their shares of the fund at the same time, it will pose problems for the fund manager trying to meet redemption requests. Most likely, the manager will be forced to sell some bonds, potentially at a discount, as the fund needs to simply raise cash to meet redemptions.
Some in the market have attributed the sharp market swings seen during the downturns in October and December as indicating structural problems with liquidity in the market — and some fingers have been pointed at the proliferation of bond funds.
And the Fed is clearly watching this.