The Securities and Exchange Commission’s Division of Investment Management (IM) is worried that the primary dealers of the fixed income world might not have enough capacity to make markets effectively if volatility spikes because bond fund flows rapidly turn negative. The question has pertinence to treasury investment managers since such outflows crippled the MMF market for a short time in 2008, gumming up corporates’ access to needed cash.
The IM issued guidance earlier this month entitled, “Risk Management in Changing Fixed Income Market Conditions.” As context, the agency notes that net assets of bond mutual funds and ETFs are at “near-historic highs of $3.6 trillion” with $2 trillion of this coming since 2008. The taper vapors back in June caused a 1.8% outflow from bond funds. While that’s not unprecedented, it occurs in a time when the market fundamentals have changed somewhat.
The problem is, primary dealers now hold inventories similar to those they had in 2001, despite the market’s growth by a factor of four since then, according to IM. This is a much bigger disparity than was seen even in the 2008 crisis, and it raises the question of whether they are capable of making markets effectively in a time of crisis. Prior to the crisis, primary dealer inventories were 4 percent of the total market. Now they are 0.5 percent.
IM’s intended audience is investment fund managers, and so it goes on to issue some reasonably mundane risk management best practice suggestions, such as make sure stress tests account for liquidity, and let your customers know what they’re in for. Treasury investment managers need to consider the additional liquidity risk as well as the market risk they could run due to the change in the dealers’ ability to make markets during a crisis.