This Time IS Different, Credit Shop Argues

Having learned their lessons after the financial crisis, investors may be overlooking bigger risks, according to new research.

Michael Nagle/Bloomberg

Michael Nagle/Bloomberg

When fixed income markets inevitably freeze up again, asset managers better have a plan to deal with investors who have been promised they can redeem their shares on a daily basis — but can’t.

The so-called asset liability mismatch exists between a fund structure offering daily redemptions and illiquid primary markets for underlying securities, such as corporate bonds. This mismatch is among the biggest risks for fixed income investors since the financial crisis, according to a new paper. The research addresses five key changes that the paper’s authors believe are largely unrecognized and which will be huge factors in causing the next crisis in fixed income markets, including leveraged loans and private credit.

“People who have expectations of quick liquidity don’t like to be told that there is none right now. In open-ended structures, something has to be sold to pay you,” Daniel Zwirn — CEO and chief investment officer of Arena Investors, and one of three authors of the paper — told Institutional Investor in an interview. “There are hundreds of billions of securities in the OTC [over-the-counter] fixed income market in these structures. If you take something like leveraged loans and OTC corporate credit that has the liquidity of cement, like corporate credit, and then you wrap it in an ETF, it’s still cement,” he added in an interview.

Zwirn explained that the compliance culture of asset managers, which have been under increased regulatory scrutiny in the past decade, may make the problem of asset-liability mismatches worse. To protect against litigation, for instance, compliance officers may suspend redemptions if they don’t have enough information to determine a fund’s net asset value. Gated funds could cause a panic in the markets.

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The risks of fixed income funds are one of five key interelated risks laid out in the report. Sweeping regulatory changes, including the Volcker Rule that prohibits banks from engaging in proprietary trading, as well as investors’ hunger for yield have altered the dynamics of market-making, argued Zwirn and co-authors Jim Kyung-Soo Liew (assistant professor in finance at the Johns Hopkins Carey Business School) and Ahmad Ajakh (co-founder of Fitzroy Capital Management and a lecturer at Carey Business School). Regulators essentially fueled the transformation of lending where banks once were the primary actors, to asset managers, whose long-term investors have instead provided capital for businesses.

As a result, it will be increasingly difficult for investors to get accurate prices as well liquidity information on corporate bonds and other securities, particularly during the next downturn. The paper also laid out related changes that have added other risks to fixed income markets, such as corporate bonds’ deteriorating quality and the rise of leverage at middle-market companies.

The paper presented evidence that certain sectors such as auto loans — which the authors compare to subprime mortgages pre-2008 — and collateralized loan obligations could be particularly at risk when the credit cycle ends.

Zwirn said expectations that asset managers will somehow bail out the markets and provide liquidity are unrealistic. He explained that large alternative investment managers have increasingly raised money from investors for specialized funds. In stressed markets, these managers won’t be able to invest outside their narrow mandates.

Another reason investors can’t expect asset managers to save the market is their relatively small size. Fixed-income hedge funds had $556 billion in assets under management, about six percent of the $9.2 trillion corporate bond market. “Given their relatively small size, it is simply impossible for hedge funds to ‘become the market’ and absorb large liquidity shocks,” according to the report.

Regulators have been successful in shifting risk away from banks. “But it’s just moved,” said Zwirn. According to the paper, “this merely shifted the same leverage risk to insurance companies, pensions, and other institutional investors by way of private fund offerings.”

Leveraged loans and collateralized loan obligations are two other big worries for the paper’s authors. Leveraged loans now represent 9 percent of corporate credit in advanced economies, according to the paper. Eighty percent of outstanding leveraged loans are covenant-lite, meaning investors don’t have protections when companies default. CLOs, which package floating rate loans, double down on that risk.

“What CLOs do is to effectively turn these dubious debts into securities with high investment grades, creating a false sense of safety for investors,” according to the paper. “Furthermore, as investor demand for securities increases, credit quality and underwriting standards for leveraged loans are deteriorating. CLO managers with little or no skin in the game are willing to accept higher debt multiples and weaker covenants. This same problem of lenders being incentivized to take outsized risks was a primary root cause of the 2008 financial crisis.”

Zwirn believes investors need to better understand the secular changes that have occurred in the markets. Absent any changes by regulators or central bank policies on loose monetary policy, Zwirn recommends investors hold some cash to protect themselves. “There are worse things than having cash,” he said.