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A few hard lessons on liquidity

| January 22, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Taxable bond mutual funds last year faced one of the biggest runs on liquidity in their history, just the latest episode of liquidity stress in the last decade. The lessons learned have almost certainly left their mark on fund asset allocation. Those lessons may pay well at some point this year, too.

Managers of taxable bond mutual funds have learned the value of liquidity through hard experience. In stressful markets, mutual fund investors want their money back, and managers have to come up with it. In the eight weeks between February 19 and April 15 last year as Covid shut down economies worldwide, US mutual funds saw nearly $243 billion in redemptions (Exhibit 1). In contrast, taxable bond ETFs saw only $10 billion in redemptions

Exhibit 1: Taxable bond mutual funds have faced outflows in stressful markets

Source: ICI, Bloomberg, Amherst Pierpont Securities

The demand for cash from mutual fund investors has played out repeatedly since at least 2012:

  • After the taper tantrum in mid-2013
  • As the energy market collapsed from mid-2014 into 2016, and
  • As a tightening Fed drove rates up and spreads wider in late 2018

In each case, mutual fund AUM dropped quickly while ETF balances rose or only dropped by relatively small amounts.

The vulnerability of mutual funds to liquidity runs likely reflects their heavy share of retail investors compared to the larger stake of institutional investors in ETFs. Runs by retail investors look different than runs by institutional investors. A recent study by the New York Fed broadly argues that retail money market fund investors last March ran when they saw other investors running while institutional investors ran only if structural elements of the mutual fund, like redemption gates or fees, might limit access to their money.

The history of surges in redemptions for taxable bond mutual funds has almost certainly left a mark on their managers and raised the importance of liquidity in the fund assets. At the end of 2020, for example, the 20 largest taxable bond funds benchmarked against the Bloomberg Barclays US Aggregate Bond Fund Index had a weighted average of 2% of assets in cash, 39% in MBS and 25% in government debt with the balance largely in corporate debt. The cash is likely there for routine redemptions, but large parts of the MBS and government allocations represent liquidity disaster insurance.

Despite the liquidity strains, taxable mutual funds last year generally performed well. The 20 largest funds outperformed the Bloomberg Barclays Aggregate US Bond Market Index after expenses by an AUM-weighted average of 30 bp—but with significant dispersion (Exhibit 2). Although 14 out of the Top 20 beat the broad market, some of the largest funds underperformed and dragged down the weighted Top 20 average.

Exhibit 2: Most of the Top 20 beat the index

Source: Bloomberg, Amherst Pierpont Securities

Mutual fund performance also looked good last year after accounting for return volatility. Information ratio is a common measure of the stability of excess return. It expresses excess return in terms of standard deviation. An information ratio of 1, for example, indicates a fund produced excess return 1 standard deviation above zero. The Top 20 had a weighted average information ratio last year of 0.40, a strong showing.

Despite the relatively good performance against their market index, the correlation between 2020 excess returns—returns above the market index—and in prior years showed again that picking a winner from year to year is a tough game. Excess returns in the 20 largest funds correlated on 0.49 with returns in 2019, were negatively correlated to returns in 2018 and very lightly correlated to returns before that (Exhibit 3).

Exhibit 3: Mutual funds’ relative returns year-to-year are hard to predict

Source: Bloomberg, Amherst Pierpont Securities

Although liquidity across fixed income is strong for now, taxable bond mutual funds are not out of the woods yet. The course of QE is clearly under discussion at the Fed and in the markets, and shifts in QE pose risks to rates, spreads and, of course, to liquidity. The taper tantrum of 2013 led to redemptions. Lessons learned from experience will likely pay well this year, too.

* * *

The view in rates

Discussion of the new administration’s bid for $1.9 trillion in fiscal spending continues. Little has changed over the last week. The market for now probably prices in another $1,400 in payments to eligible taxpayers, some extension of unemployment benefits, some funds to state and local governments and some infrastructure spending. That probably comes to an expected $1 trillion to $1.25 trillion. As expectations go above or below that range, rates should move accordingly. The Treasury yield curve has finished its most recent session with 2s10s at 96 bp, little changed from last week, and 5s30s at 142 bp, up slightly from last week. Inflation expectations have remained relatively steady at 208 bp, just a few basis points below the high point for the year.

The view in spreads

Spreads should continue to tighten further despite being near or at historic tights. Tremendous net Treasury supply is creating a surplus of the riskless benchmark while QE absorbs MBS, the relatively riskless spread asset, at least regarding credit. Beyond the influence of net Treasury supply, fiscal stimulus, pandemic recovery and Fed policy should also keep spreads steadily tighter through 2021. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt. Consumer credit should outperform corporate credit.

The view in credit

Consumers in aggregate are coming out of 2020 with a $5 trillion gain in net worth. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Although there is an underlying distribution of haves and have nots, the aggregate consumer balance sheet is strong. Corporate balance sheets have taken on substantial amounts of debt and will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. Credit in the next few months could see some volatility as Covid begins forcing shutdown of some economic activity and distribution of vaccines potentially hits some logistical potholes. But distribution and vaccine uptake through next year should put a floor on fundamental risk with businesses and households most affected by pandemic—personal services, restaurants, leisure and entertainment, travel and hotels—bouncing back the most.

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