IMF flags high level of bond fund lev­er­age

The Pak Banker - - FRONT PAGE -

The In­ter­na­tional Mon­e­tary Fund is call­ing for fund man­agers to be more trans­par­ent about the amount of lev­er­age they use in bond mu­tual funds, amid con­cerns those lev­els might be high enough to cause a crash.

Ac­cord­ing to IMF re­search, bond funds have in­creased their use of de­riv­a­tives sig­nif­i­cantly since the global fi­nan­cial cri­sis. This can lead to high lev­els of lev­er­age, where a fund has po­ten­tial obli­ga­tions greater than the as­sets it holds. How­ever, only ded­i­cated dig­ging through the ap­pen­dices of an­nual re­ports dis­closes any in­di­ca­tion of the scale of this ac­tiv­ity.

"The less trans­par­ent things are, the greater the risk of neg­a­tive sur­prises," says Fabio Cortes, an econ­o­mist in the IMF's mon­e­tary and cap­i­tal mar­kets depart­ment. Cortes re­cently pub­lished a blog post call­ing on reg­u­la­tors to de­mand bet­ter dis­clo­sure of funds' use of de­riv­a­tives. Mara Do­brescu, a fund an­a­lyst at Morn­ingstar, the data provider, says: "If you look at the fact sheet [ for a fund], there is no in­for­ma­tion on de­riv­a­tive po­si­tions. That is one data point you re­ally don't want to rel­e­gate to a foot­note."

Re­search shows a num­ber of large main­stream bond funds have re­ported high lev­els of lev­er­age in their an­nual re­ports. Black­Rock's Fixed In­come Global Op­por­tu­ni­ties fund had an av­er­age lev­er­age of 746 per cent over 2014. Pimco's Global Bond ex-US fund and Gold­man Sachs' Global Strate­gic In­come Bond Port­fo­lio had lev­er­age of 468 per cent and 674 per cent re­spec­tively over the same pe­riod. Al­though th­ese lev­els of lev­er­age are com­mon, be­cause the use of de­riv­a­tives is com­mon, not all bond funds adopt the same ap­proach. Van­guard's fixed in­come ETFs and Franklin Tem­ple­ton's bond funds es­chew all use of de­riv­a­tives.

The in­for­ma­tion on lev­er­age lev­els, al­though scant, is only avail­able be­cause it is a re­quire­ment un­der the Ucits leg­is­la­tion that gov­erns the Euro­pean retail fund in­dus­try. In the US, there is no re­quire­ment to make such dis­clo­sures, al­though the Se­cu­ri­ties and Ex­change Com­mis­sion, the reg­u­la­tor, said in De­cem­ber it is con­sid­er­ing chang­ing that. The pro­posed SEC regulation would limit funds' use of de­riv­a­tives and re­quire them to put risk man­age­ment mea­sures in place that would re­sult in bet­ter in­vestor pro­tec­tion. "De­riv­a­tives can raise risks for a fund, in­clud­ing risks re­lated to lev­er­age, so it is im­por­tant to re­quire funds to mon­i­tor and man­age de­riv­a­tives-re­lated risks and to pro­vide lim­its on their use," said Mary Jo White, who chairs the SEC, when an­nounc­ing this plan. Pro­po­nents say there are two rea­sons this is im­por­tant.

First, in­vestors should have all mean­ing­ful in­for­ma­tion avail­able to them be­fore putting money into a fund. The risk is not just of los­ing money thanks to bad bets, says Daniel Davies, a se­nior re­search ad­viser at Front­line An­a­lysts. "The risks that non-lever­aged de­riv­a­tives add are all op­er­a­tional: com­plex­ity and ad­min, plus maybe some coun­ter­party risk if the col­lat­eral is not posted daily. They are not noth­ing," he says.

Large fund houses such as Black­Rock and Pimco will prob­a­bly have the re­sources to man­age th­ese op­er­a­tional risks, and their record sug­gests they know how to do this, but this is not some­thing that can be en­cap­su­lated in a sin­gle met­ric. Do­brescu says of the Pimco fund: "It makes heavy use of de­riv­a­tives, in part be­cause of the size of the fund, which means they need to use them to side­step liq­uid­ity is­sues. But Pimco has the in­fra­struc­ture, the ex­per­tise, the man­power to mon­i­tor this, so we are com­fort­able with it."

The se­cond is­sue, which is the main rea­son the IMF wants greater trans­parency, is that it is im­pos­si­ble to get a sense of whether such high lev­er­age lev­els are adding sys­temic risk to bond mar­kets, which are al­ready strug­gling with liq­uid­ity short­ages. "We see this as an am­pli­fier of risk," says Cortes. "It could ex­ac­er­bate in­vestor losses" in the event of a mar­ket down­turn, he adds.

Most of the funds show­ing high lev­er­age lev­els are in­vested in a wide range of bond sec­tors, from US Trea­suries, to emerg­ing mar­ket bonds, to junk bonds and as­set backed se­cu­ri­ties. This is fur­ther cause for con­cern. "They are multi-sec­tor, which could in­crease the risk of con­ta­gion," he says. But the high lev­er­age lev­els among the funds that do dis­close this data may not be as alarm­ing as it seems, ac­cord­ing to in­de­pen­dent com­men­ta­tors. The way the lev­er­age is cal­cu­lated means it is im­pos­si­ble to tell from that num­ber how much risk de­riv­a­tives add to the fund.

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