IMF flags high level of bond fund leverage
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.