Tuesday, October 21, 2014

IMF Direct Article asks: What Could Make $3.8 Trillion in global bonds go up in smoke?

In what now seems like an almost daily event, the IMF posts this article warning that $3.8 Trillion in global bonds could "go up in smoke" when the Fed starts raising interest rates. The solution? Make it harder for investors to get at their money invested in the bonds. Below is pasted the Twitter page from IMF Direct asking the question. Below that are some quotes from the article. Readers should read the entire article linked above for full context.


From IMF Direct Twitter page:

IMF@IMFNews · Oct 15
What could make $3.8 trillion in global bonds go up in smoke?

Some quotes from the article:

"Low interest rates and other central bank policies in the United States have sent investors looking for higher returns on their investments. Money is pouring into mutual funds and exchange-traded funds, which is fueling a mispricing of credit and a build-up of risks to liquidity in the markets—the ability to trade in assets of any size, at any time, and to find a ready buyer."

"In our latest Global Financial Stability Report, we analyze this trend, which can create an illusion of liquidity. It turns out what we face is really a liquidity mismatch because investors can sell their mutual funds or exchange-traded fund investments almost anytime, but these funds have in turn invested their money in instruments that don’t trade quite as often, such as high-yield bonds."

"While this is not a problem in good times, markets can turn volatile when the U.S. Fed starts to raise interest rates, particularly if this happens in an unexpected way. If that were the case, there is a risk that many investors would want to start selling all their holdings at once, causing asset prices to drop, which would then lead to further selling by investors, which may in turn create a vicious circle of further losses and more selling."

. . . . . . .  .

$3.8 trillion up in smoke

"The result of a rapid switch to highly volatile markets would drive a faster rise in term premiums, and widening credit spreads would spill over to global markets. For example, we estimate that an unexpected market adjustment (in interest rates) that causes term premia in bond markets to revert to historic norms (a 100 basis points increase) and credit risk premia to normalize (a repricing of 100 basis points) could rapidly push up bond yields (Chart 3), reducing the market value of global bond portfolios by over 8 percent—that’s $3.8 trillion."

"These risks to exit mean officials need to address the existing liquidity mismatches. They can do this through prudential policy measures such as removing incentives of asset owners to run—by aligning redemption terms of funds with the underlying liquidity in the assets invested."

Update 10-22-14: Bloomberg runs an article on this problem and cites IMF study.

Added note 8-6-15: A full list of systemic risk warnings can be found on this blog page 

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