US fund firms are taking extra measures to make sure they don’t get stuck holding hard-to-sell bonds in the event that fixed income markets see a massive race to the exits when interest rates start to rise.
Over the past few months a growing number of asset managers, including Neuberger Berman, Natixis Global Management and T Rowe Price have been testing their funds against various market scenarios, building cushions of cash, shorter-duration bonds and other liquid securities, and regularly discussing risks with their boards.
The concern is this: As the Federal Reserve begins to raise rates, which many expect will begin to happen next year, investors will rush to sell bonds as their value drops in a rising interest rate environment. Historically Wall Street banks have been the buyers of these bonds, but regulations and capital requirements imposed since the financial crisis have forced these firms to slash their inventories.
“I look around and ask ‘at the end of the day how easy would it be to sell what I own?’, and the answer is it is much more challenging,” said Jason Brady, a fixed income portfolio manager at Sante Fe, New Mexico-based Thornburg Investment Management, which has $70bn in assets under management, $17bn of which is in fixed income.
Wall Street’s biggest banks don’t believe the Fed will raise rates until the middle of next year at the earliest. In a survey taken in early October, 14 of the 19 primary dealers, or the banks that deal directly with the Fed, said they expect the first rate hike by June 2015, with borrowing costs rising to 1 percent at the end of that year.
But fund managers say they are already seeing signs of it getting harder to buy and sell bonds.
Many managers were spooked in mid-October, when the yield on 10-year Treasury notes fell quickly to 1.865 percent, their lowest level since May 2013.
“When all of a sudden the most liquid market out there isn’t liquid, it’s worrisome,” Brady said.
Buffers
Thornburg and T. Rowe are among a number of firms that have increased their allocations to cash to provide their portfolios with a buffer in the case of a liquidity crunch. Thornburg’s $1.3bn Strategic Income Fund has increased its allocation to cash to 13% from 10% last year and has also increased its holdings in shorter-duration bonds and high grade investment debt, Brady said.
T Rowe’s High Yield Fund has 3% in cash, up from 1% a year ago, said Mark Vaselkiv, manager of the fund.
Instead of cash, Natixis has built up a reserve of as much as 20 %in some of its mutual funds in higher quality, non-US securities, such as bonds denominated in Australian and Canadian dollars, said David Lafferty, chief market strategist at Natixis. As of September 30, Natixis had $894.3bn in assets under management and its subsidiary, Boston-based Loomis Sayles & Co, had $223.2bn.
Firms, like New York-based Voya Investment Management, which uses third party managers to subadvise its funds, now give high-yield bond managers up to three days notice before it makes big redemptions out of those funds to make sure they can get the money in an orderly and timely fashion, said Paul Zemsky, CIO of multi-asset strategies at Voya, speaking on Tuesday at the Reuters Global Investment Outlook Summit in New York.
