There is a $1.4 trillion 'contagion' time bomb sitting inside mutual funds (but don't worry it will probably turn out just fine)

One of the great things that banks have started doing since the 2007 credit crisis is to apply some proper detective work to sectors that might conceal catastrophic weaknesses that could suddenly tank the global economy, again.

In a recent note to investors, UBS analyst Ramin Nakisa and his team are not saying they have found one.

But … maybe we should just all take a look at this thing.

Just in case.

Nakisa writes that in the US there are currently $US18 trillion (£11.71 trillion) in assets under management in the form of mutual funds. (A mutual fund bundles stocks or bonds together to form a type of mostly safe portfolio suitable for 401(k) investors and other retirement funds.)

Of that $US18 trillion, $US1.4 trillion (£910 billion) is in the form of “hybrid” mutual funds, which use a combo of equities (like stocks) and credit (like bonds). The problem with bonds is that the bond market can become suddenly very illiquid, meaning difficult to sell. And when companies and institutions start losing money suddenly on their bond investments, they often need to cover those losses by selling stocks, which are as liquid as cash.

So what we don’t want to see is a sudden selloff of credit vehicles, Nakisa writes.

Because that might cause “contagion,” a word that appears three times in Nakisa’s most recent note. “Contagion” was also the subject of an entire note from Nakisa back in February. (The title said it all: “US energy credit defaults: should we fear contagion for other assets?”) Contagion is when a selloff in one sector drives a selloff in another, at which point everything goes to hell.

Anyway!

That probably won’t happen, Nakisa writes. But if you’re afraid it might, UBS prepared this chart showing what the hybrid mutual fund credit/equity problem looks like right now:

So what would trigger this meltdown? A “systemic shock,” Nakisa says:

… hybrid mutual funds (a) hold significant amount of credit alongside equity, (b) the equities held include companies with AAA credit scores, such as Microsoft, and have greatest exposure to the Utilities, Energy and Materials sectors and (c) the selloff in credit so far has happened without any large mutual fund outflows. We believe we would need to have a systemic shock in order to trigger a liquidity problem in credit such as a further fall in oil, another sharp dollar rally or another negative growth surprise from EM, hence this scenario is a tail risk, but one that in our opinion cannot be ignored.

So, things will probably be just fine. Right?

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