Fed looks at exit fees on bond funds

Washington: Federal Reserve officials have discussed imposing exit fees on bond funds to avert a potential run by investors, underlining regulators’ concern about the vulnerability of the $10tn corporate bond market.

Officials are concerned that bond-fund investors, as with bank depositors, can withdraw their money on demand even though the assets held by their funds are long-term debt and can be hard to sell in a crisis. The Fed discussions have taken place at a senior level but have not yet developed into formal policy, according to people familiar with the matter.

“So much activity in open-end corporate bond and loan funds is a little bit bank like,” Jeremy Stein, a Fed governor from 2012-2014 told the Financial Times last month, just before he stepped down. “It may be the essence of shadow banking is ... giving people a liquid claim on illiquid assets.”

In the wake of the financial crisis, tougher rules on capital and the abolition of in-house trading operations at major US banks have resulted in Wall Street pulling back from helping big funds buy and sell corporate bonds. Bank inventories of bonds have fallen almost three-quarters from their pre-crisis peak of $235bn, according to Fed data.

At the same time, US retail investors have pumped more than $1tn into bond funds since early 2009. This has created a boom environment for fixed income money managers, but raises the prospect of a massive disorganised flight of money out of the industry should interest rates rise sharply in the coming years.

Exit fees would seek to discourage retail investors from withdrawing funds, thereby making their claims less liquid and making a fire sale of the assets more unlikely.

Introducing exit fees would require a rule change by the Securities and Exchange Commission, which some commissioners would be expected to resist, according to others familiar with the matter.

Such fees could be highly unpopular with retail investors unable to access funds without paying a fee. But some in the industry would welcome them; BlackRock, the world’s largest asset manager, has called for international rules setting exit fees on some funds.

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Even as regulators worry about the potential of a sharp correction in the bond market, some investors are building a war chest to take advantage of it. BlueMountain Capital, the New York-based alternative asset manager, has stockpiled funds it calls “patient capital”, ready to be deployed when bond prices fall.

“If we see something like this happening and our best guess is it will stabilise 10 points down, we’ll wait,” said Andrew Feldstein, co-founder and chief executive of BlueMountain.

“It’s perfectly within the mandate of the fund to go buy a bunch of corporate debt at 85. When the market gets liquid and the bonds trade back up to 95, we can sell it and go do something different, and that’s in some way what the banks used to do.”

Investors like Mr Feldstein and regulators like Mr Stein have a similar vision of how the dislocation could arrive. “Big picture, credit risk-taking has migrated out of banks to mutual funds,” said Mr Feldstein.

“Mutual funds aren’t leveraged and banks are, so that should take some of the systemic risk out of the system, but mutual funds have daily redemptions and so ... they certainly do engage in the maturity transformation that banks do.”

— Financial Times