Money managers with $160 trillion at stake are vulnerable to a disaster of their own making

Large asset managers face a heightened risk of big losses in their fixed-income portfolios, according to the Bank for International Settlements.

This was one of several risks to the financial system that the BIS, nicknamed the bank for central bankers, flagged in its 2018 economic report. Also on the theme of debt, the BIS warned that growing levels of public and private borrowing are creating a trap that would be tough to escape as interest rates rise.

Low interest rates have amplified both risks, the BIS said. With yields historically low and convenient exchange-traded funds booming over the past decade, institutional asset managers amassed nearly $160 trillion in assets, the BIS estimated. The asset managers in question are non-bank firms such as pension funds.

Bond prices rose as their yields fell, increasing the valuation of fixed-income instruments in many of these large asset managers’ portfolios. But they couldn’t ride this gravy train forever, since persistently lower yields implied that new bond purchases would produce lower yields in the future.

Consequently, many asset managers tackled this yield conundrum by scooping up riskier debt and extending the duration of their bond holdings. The risk investors have been willing to take is so pronounced that Bank of America Merrill Lynch sees parallels between the ongoing strain in emerging-market bonds and the 1998 Asian financial crisis.

“Taken together, these factors suggest that sensitivity to snapback in both interest rates and volatilities has increased,” the BIS said.

“Various structural features of the asset-management industry may contribute to magnifying this vulnerability. One is a high concentration of assets under management, which can result in a clustering of risks within a limited number of large asset management companies.

Open-ended mutual funds, which are more flexible for investors seeking to cash out, would be especially vulnerable in a selloff, the BIS said.

The BIS further flagged that volatility-linked products, which sell when the underlying index declines, that can make a selloff even worse.

“Structural changes in the asset management industry suggest that shock propagation can work through new, market-based channels that may amplify price movements relative to pre-crisis,” the BIS said. “Thus, even though banks and other intermediaries have become more resilient, snapback and similar shocks could lay bare new vulnerabilities.”

For examples of the snapback risk, the BIS identified recent periods when the 10-year yield jumped by at least 80 basis points before dropping again. In each episode, open-end mutual bond funds suffered outflows.

Source: Business Insider

 Trader Aleksandar Kumanov

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