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With St Louis Fed president James Bullard saying that markets were probably mistaken if they expected interest rate increases to occur more slowly than policymakers forecast, money managers such as BlackRock have called on regulators to forestall a potential liquidity crisis. Photo: Thomas Yau

Cash pile mitigates liquidity worries in US bond market

Given debt fund managers' strong cash position, depletion fears due to a flood of redemptions in the wake of rising rates seem to be overblown

BLOOM

The record US$3.5 trillion stockpiled in United States fixed-income funds is raising the spectre that the bond market will buckle under the strain of redemptions once interest rates rise. Simple mathematics suggests there is little need to worry.

While fund assets have almost doubled since the financial crisis, their size as a portion of US mutual funds is still in line with the 21 per cent average over the past three decades, according to the Washington-based Investment Company Institute. Debt fund managers also hold almost 9 per cent of assets in cash, close to the highest in 25 years and more than the maximum rate of outflows in 1994, one of the worst years for bonds.

With St Louis Fed president James Bullard saying that markets were probably mistaken if they expected interest rate increases to occur more slowly than policymakers forecast, money managers such as BlackRock have called on regulators to forestall a potential liquidity crisis that may deepen a sell-off if too many investors try to get out at once. While a fall in bonds that economists have predicted all year may finally materialise, JP Morgan Chase says withdrawals are unlikely to unleash a flood of selling that upends debt markets.

"The worries are overblown," said Nikolaos Panigirtzoglou, a London-based global market strategist at JP Morgan. "If you look at history, it's clear investors aren't over-invested and bond funds are well positioned."

The stakes have never been higher for the Federal Reserve to engineer a soft landing from almost six years of near-zero benchmark rates as the amount of outstanding public debt in the US hits a record US$17.7 trillion.

Debt securities of all types, from treasuries to junk bonds, have rallied this year and confounded forecasters who foresaw losses as the Fed scaled back the extraordinary stimulus that has supported the economy since 2008.

The 4.9 per cent average return is the most since 2011 on a year-to-date basis, according to data from Bank of America.

Yields on 10-year treasuries, the benchmark for trillions of dollars of securities, fell last week to the lowest level since June last year as the deepening conflict between Russia and Ukraine boosted demand for haven assets. Yields have dropped 0.69 percentage point this year and ended at 2.34 per cent last week.

The bond market had been supported by individuals pouring money into fixed-income mutual funds, which had boosted their assets by US$1.77 trillion since 2008, said ICI, the industry's trade association.

The enthusiasm for bonds has raised the risk that a sudden jump in yields could cause a flood of redemptions and magnify losses, according to BlackRock, the world's largest money manager.

The New York-based firm, which oversees US$4.32 trillion, published a report in May saying regulators should consider limits on some withdrawals and standardise provisions that would let funds under duress hand over bonds instead of cash.

"Minimising 'run risk' will mitigate systemic risk," the report said. Spokeswoman Tara McDonnell said on Friday the firm still held that view.

While the surge in bond demand since the financial crisis has given credibility to the notion that the risks to investors have rarely been greater, it does not tell the whole story.

Bond funds account for 22 per cent of the US$15.66 trillion US mutual fund industry, just 1 percentage point more than the average since 1984, ICI said. At the same time, fixed-income funds have increased their cash cushions to 8.7 per cent of assets from 7.3 per cent a year ago.

That is more than the historical average of 5.4 per cent. On a quarterly basis, the funds have had more liquid assets only once in the past 30 years - in the second quarter of 2011.

During 1994, when US debt securities lost 2.75 per cent in the worst year on record, outflows never exceeded 6 per cent of bond fund assets in any quarter, according to JP Morgan.

Bond managers are more prepared to meet redemptions after last year's 2.25 per cent sell-off, dubbed the "taper tantrum", caused yields on 10-year treasuries to rise about 1.4 percentage points in four months and triggered the longest stretch of outflows from bond funds since 2000.

Ira Jersey, an interest rate strategist at Credit Suisse, said on Thursday the "risk of a system-wide cash depletion seems unlikely" because bond funds had boosted liquidity.

This article appeared in the South China Morning Post print edition as: Cash pile mitigates liquidity worries in US bond market
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