Remarks (with slides) at the Brookings Institute. Liquidity in Financial Markets Barbara Novick, Vice Chairman. Washington D.C.

Transcription

1 Remarks (with slides) at the Brookings Institute Liquidity in Financial Markets Barbara Novick, Vice Chairman Washington D.C. November 15, 2016 Introduction Martin, thank you for inviting me to speak at Brookings today. I'd like to talk about both bond market liquidity and fund redemption risk, and the linkage between them. Given the time constraints, I will touch on a just a few highlights of the conversation. I welcome additional engagement with anyone interested in this topic. Discussions on bond market liquidity began with two important data points: 1. Bonds funds were holding an increasing percentage of outstanding bonds, and 2. "Turnover" was declining in bond markets. Needless to say, these points raised alarms about potential new risks and became the focus of numerous research papers and media stories. So let s start by understanding the data behind these two assumptions. Ownership of Bonds by Mutual Funds As this conversation unfolded, I struggled with the arguments made in these reports. It seemed that new issue volume was at all-time highs. And, our bond traders said they never went home with unfinished business. How could this disparity be? The first assumption that bond funds owned an ever-increasing percentage of corporate bonds turned out to be based on incorrect data. In fact, the Federal Reserve Z.1 data measuring corporate bond ownership was recently revised. In this chart, the green line shows the original Federal Reserve data with ownership doubling from 12% to 24% between 2009 and This past summer, the Fed found an error in their methodology and released corrected data, including a restatement of historical numbers. The corrected data the blue line shows more muted growth than previously believed, and shows a flattening of the curve starting in The new data shows mutual funds holding approximately 17% of corporate bonds with little growth since

2 % of Corporate and Foreign Bonds Held by Open-End Mutual Funds Source: Federal Reserve's Z.1 Financial Accounts of the United States Statistical Release. Original data from Dec release. Corrected data from Sep release. Chart includes quarterly data from fourth quarter 2009 through third quarter 2015 to illustrate corporate and foreign bond ownership by mutual funds following the 2008 Financial Crisis. Graphs represent total corporate and foreign bonds included in Fed Z.1 data. Bond Turnover When I started looking into the second assumption on bond "turnover", I was surprised to discover that turnover is a ratio of secondary trades divided by outstanding bonds. Strong new issuance substantially increased the number of outstanding bonds the denominator. Although secondary trading was rising, the ratio showed a decline because the amount of outstanding bonds increased faster than secondary trading. As you can see in these two charts, this applies to both the US investment grade and high yield sectors. When people heard that bond turnover was decreasing, many believed that measure referred to trading volume, as the ratio was generally used without further explanation. US Investment Grade Volume, Outstanding, and Turnover US High Yield Volume, Outstanding, and Turnover Source: MarketAxess. As of Dec. 31, In addition, recent earnings reports from financial firms highlight increased revenue from bond trading. For example, Goldman Sachs saw a 34% year-over-year increase in Fixed Income, Currency and Commodities Client Execution (FICC) revenues. Morgan Stanley saw a 157% year-over-year increase in Fixed Income sales and trading revenues. This reinforces the point that bond trading volumes remain significant. 2

3 Asset Owners in the Ecosystem One area that is not often discussed is the importance of factoring in the entire asset management ecosystem. Several studies show that between two thirds and three fourths of financial assets are managed directly by asset owners. So, who are the asset owners? There are different kinds of asset owners with diverse investment objectives and constraints. Source (unless otherwise noted below): Asset Management 2020: A Brave New World. PWC. Data as of PWC analysis based on data from various sources including Credit Suisse Global Wealth Data Book, SWF Institute, TheCityUK, OECD, and Insurance Europe. Available at Some assets may be double counted. a. Represents largest 25 Banks. Source: As of b. Source: McKinsey & Company. As of c. Source: Cerulli estimates for US single-family offices. As of November Limited data available on family office assets. d. HNWIs are defined as those having investable assets of US $1 million or more, excluding primary residence, collectibles, consumables, and consumer durables. For example, an insurer generally holds a lot of fixed income assets and pays taxes. This does not change if rates move or if currencies move or if fixed income goes out of favor. Insurers have a built-in incentive to hold fixed income, considering their capital requirements and their liabilities. In fact, if rates go up, they have an incentive to buy fixed income bonds because they need that yield. Another category of asset owners is pension funds. There are several different kinds of pension funds defined benefit plans and defined contribution plans, as well as public funds and corporate funds. These pension funds have important differences. For example, let s look at defined contribution plans. In the defined contribution market, the take-up of target date funds over the past 10 years has been considerable, in part because a defined contribution plan may use a target date fund as a default option. These funds rebalance to an asset allocation target glide path, meaning they act countercyclically. If bonds perform poorly, they will increase their allocation to fixed income. If stocks perform poorly, they will increase their allocation to equities. These are just a couple of examples and in fact there are many more. This diversity is critical to understanding market liquidity. The idea that all asset owners are going to act in concert is a flawed concept that is not supported by data. 3

4 Another area that is often overlooked is the impact of asset owners on the asset allocation decisions who controls asset flows? While much of the literature suggests asset managers control asset allocation, this does not capture the complexity of the asset management ecosystem. An asset owner, such as a pension fund or an insurance company, might make a huge shift in their portfolio. Importantly, asset owners hire asset managers for specific mandates, and decide when to make changes. Asset owners decide how to allocate their portfolio and whether to manage assets directly or hire an external asset manager. An asset owner might decide to change asset managers if they change their asset allocation. Understanding who controls these asset flows starts with looking at the investment objectives and constraints of the asset owners and who makes asset allocation decisions. Case Studies Let s examine two examples of significant market shifts and what I will label idiosyncratic events. These events reinforce the importance of looking at the entire ecosystem to understand asset flows and the impacts on our financial system. The first example is looking at what happened just after Bill Gross announced his departure from PIMCO on September 26, Following this announcement, some asset owners decided to stay put while others decided to leave. Many of these decisions were made after consulting with outside advisors and oversight committees. As a result, assets moved over a relatively long period of time. Second, these flows dissipated across the asset management ecosystem with numerous firms experiencing inflows. PIMCO Total Return Fund Daily Outflows (Sep. 2 Oct. 31, 2014) Source: PIMCO Statement Regarding October Total Return Fund Net Flows, 4 November Flows for Selected '40 Act Mutual Funds (Sep. 26 Oct. 31, 2014) Source: Morningstar. Includes actively managed and index intermediate-term, short-term and unconstrained bond strategies for open-end bond funds. Excludes ETFs. Depicts firms that experienced largest fund flows for Sep. 26 Oct. 31,

5 Many of those assets stayed invested in bonds. Some went to other bond mutual funds and some went into bond ETFs. This idiosyncratic event at a single asset manager did not change the demand for the asset class just the demand for that asset manager. A sub-plot in this story is the role played by bond ETFs. We saw a spike in ETF trading volumes following the PIMCO announcement. ETFs helped many investors maintain an allocation to a broad bond market beta in the form of the Barclays US Aggregate Index as they reassessed their fixed income holdings. Keep in mind the E in ETF stands for exchange; these funds trade on exchanges rather than in the primary market, which is more of an agencytype experience. This actually adds liquidity to the bond markets. As the chart shows, despite the trading surge in ETFs, these funds continued to closely track their underlying indices at efficient levels. Index-Tracking ETFs Provide Liquidity and Price Discovery (Sep. Oct. 2014) Turnover is calculated as the aggregate notional value of each trade in a given day. Source: Bloomberg, ishares Global Business Intelligence. Past performance is no guarantee of future results. Case study shown for illustrative purposes only. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice or a recommendation regarding the ishares Funds or any security in particular. A second case study is the sudden, unexpected closure of Third Avenue s Focused Credit fund in December While some investors sold high yield bonds when Third Avenue suddenly closed its fund, other investors put cash to work seeing this as an opportunity to pick up cheap bonds. In fact, numerous yield-starved institutional investors added to high yield allocations, or established new portfolios. And again, we saw a spike in high yield ETFs reflecting the secondary market trading that enables investors to move in and out of an asset class quickly. When we think about the markets today, bond ETFs illustrate one facet of the evolution we are experiencing in fixed income. 5

6 High Yield ETF Daily Trading Volume Source: Bloomberg. As of Dec. 31, Represents average daily trading volume across all high yield fixed income ETFs. Diversity of Bond Mutual Funds A potential scenario policy makers have expressed concerns about is one in which mutual funds suddenly become mass sellers of bonds. As it turns out, there is no historical data to support this hypothesis, and in fact the available data shows the opposite. We have looked at bond funds and tried to understand how they would act in a market stress scenario. We found that bond mutual funds are far from homogeneous. Morningstar has 49 categories of bond mutual funds, which are diverse along multiple dimensions: different investment strategies, benchmarks, and underlying asset owners. 10 Largest US Open-End Bond Mutual Fund Categories Source: Simfund. As of Dec. 31, Accessed May Includes active and index open-end bond mutual funds. Excludes ETFs and fund of funds. Categories defined by Morningstar. Includes bond funds within each category. 1) Total open-end bond fund AUM is the total AUM held in dedicated US open-end bond funds as defined by Morningstar. Total AUM is $3.15 trillion as of Dec. 31,

7 We looked back to see if any category of funds had massive outflows in prior periods of market stress, including the (i) 1994 Federal Reserve rate hikes, (ii) 2008 global financial crisis, (iii) 2013 Taper Tantrum, and (iv) December 2015 high yield selloff. In our review of the largest bond fund categories during these events, no category experienced "massive aggregate outflows" during a quarterly period since 1988, even during stress events. Instead, we saw flows both into and out of various funds. The diversity of funds and asset owners is an important stabilizer of the financial market ecosystem. Because of this diversity, different asset owners have reacted differently to market stress events and we have never seen massive outflows from bond funds during a quarterly period between 1988 and Quarterly net outflows from the fund categories reviewed never exceeded 15.1% of AUM. Role of Bond ETFs As the case studies of both PIMCO and Third Avenue showed, some of the most interesting data we have uncovered in our research involves bond ETFs. Looking back at the past three years, bond ETFs appear to be growing while corporate bond dealer inventory is going down. Maybe this is a coincidence, or maybe bond ETFs are supplanting declining dealer inventories. The latter explanation makes sense as the bond market shifts from a principal over-the-counter (OTC) market to a more hybrid principal-agency structure as part of its evolution over time. Corporate Bond Dealer Inventory and ETF AUM Source: Dealer inventory data from the New York Federal Reserve as of Dec. 31, Includes Investment Grade and High Yield Corporate Bonds and Commercial Paper. Investment grade credit and high yield ETF AUM data from Bloomberg as of Dec. 31, Includes only US ETFs. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. 7

8 Market Liquidity Fund Redemption Risk None of this is to say that there are no risks and we should all become complacent. In fact, markets are changing, and we all need to evolve. At BlackRock, we are looking at things like enhanced trading capabilities such as the use of electronic trading, market structure modernization, and an evolution of new and existing products (such as ETFs). Trading today is light years more advanced than it was a decade ago. Likewise, portfolio managers are adapting in a number of ways, including through portfolio construction, liquidity risk management, stress testing of individual funds, and more. They are thinking about liquidity risk management differently. Back when BlackRock was founded 28 years ago, we identified five key risks in fixed income: liquidity risk, duration risk, convexity risk, credit risk, and currency risk. Liquidity risk is not a new risk, but it is perhaps more important today than in prior periods. Simply put, market liquidity is something we have been measuring for decades as have most other asset managers and factoring into the construction of portfolios. We applaud the various policy makers for turning their focus to products and activities across the ecosystem. In particular, expanding the toolkit of liquidity measures available to fund managers and raising the bar on liquidity risk management industrywide are positive developments. Last year, IOSCO reiterated the importance of liquidity risk management tools for funds and compared the tools in different jurisdictions around the world. Likewise the SEC's new rules limiting the inclusion of illiquid assets in US funds as well as similar initiatives in other jurisdictions will protect all of us. But we also need to be cautious. There have been recent calls for mandatory liquidity buffers, fund access to central bank liquidity, and the introduction of macroprudential tools in capital markets. While each of these ideas are interesting to study, we need to recognize that they will introduce new risks and we must weigh the tradeoffs. Let me end by observing that mutual funds are fundamentally different than bank deposits, which I think everyone would agree with. Policy making in this space needs to start with that premise and not simply try to replicate banking concepts. Thank you again, and I welcome questions and further engagement on the topics being discussed at today s event. 8

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