OREANDA-NEWS. August 13, 2015. The anticipation of an interest rate increase by the Federal Reserve this year has some investors and the media concerned that liquidity in the global bond markets will be severely tested if investors look to sell existing bond holdings en masse.

In this interview, Greg Davis, Vanguard global head of fixed income, discusses the validity of these concerns, the constancy of bond-market liquidity challenges, the steps Vanguard takes to mitigate liquidity risk, and how investors should position themselves.

Vanguard: There's been considerable talk lately that when the Federal Reserve raises interest rates, investors will sell bond holdings all at once and there won't be enough buyers. What's fueling the concerns?

Greg Davis: First, it's important to understand how we got here. Since the global financial crisis, regulation has changed the way banks and other broker-dealers are capitalized and operate. While it's made the banking system stronger and the financial system less susceptible to the risks of leverage that precipitated the crisis, it's also raised costs for banks. As a result, banks have lower risk appetites now and are much more selective about the fixed income inventory they hold, so they have reduced capacity to provide liquidity.

We've had easy monetary policies around the world for several years, and many are concerned that when rates rise, the market will dry up as everyone tries to sell their bonds at the same time, perpetuating steep losses. The question on the minds of some investors is that if there's a run for the exits, who's on the other side of those trades, and are bond funds in a position to weather a wave of redemptions?

My experience has been that a high-quality asset class with a very certain and defined income stream will always have buyers if those securities are sufficiently cheap. For example, for very high-quality investments like investment-grade bonds that pay a coupon and have a defined principal return at maturity, buyers who believe it to be attractively priced will sell equities and buy bonds. Target-date funds are another stabilizing factor. If bond markets fall, more money in these set allocations will be allocated from equities to fixed income. So there's an automatic, built-in rebalancing component in this trillion-dollar category of funds.

Can you give us a quick definition of liquidity?

Mr. Davis: Bond market liquidity means different things to different investors, but I'd say generally it's having the confidence and ability to transact at a fair, reasonable price in a timely manner.

What's getting lost in the discussion is that fixed income has always been an over-the-counter market, and the liquidity that you have in the equity market has never existed in the fixed income market, and, in particular, in the corporate bond market. Most companies have one class of common stock where liquidity is concentrated. However, a company may have hundreds of bonds outstanding, and that dilutes liquidity and makes it harder for buyers and sellers of an individual bond to find each other. Bond market liquidity is cyclical as a result of monetary policy, financing conditions for dealers, investors' risk appetite, issuance patterns, and many other drivers. Investment managers like Vanguard have always had to manage liquidity risks appropriately when investing shareholders' money. This is not a completely new phenomenon.

How realistic are today's liquidity concerns?

Mr. Davis: In short, I think the concerns are a bit overblown. It's important to keep in mind who owns bond funds. For many shareholders, bonds are buy-and-hold investments, an important part of a long-term portfolio. Investors buy bonds as a diversifier to their equity holdings and as a source of income. They don't buy bonds to speculate on short-term interest rate swings or changes in valuations. So the thesis that when rates rise everyone is going to liquidate their bond holdings doesn't ring true to me. We have a lot of history that shows that, even in times of market volatility, investors don't run for the exits. We do not believe investors will react differently when the Federal Reserve increases interest rates.

In fact, the U.S. market and some other markets have upward-sloping yield curves, meaning that the markets are already pricing in that rates are going to rise and that prospects for the U.S. economy will continue to improve. Ultimately for investors to make money by moving out of bonds, rates are going to have to rise by more than what's already priced in, and a rate rise in the United States is expected to be very gradual.

Is the rising rates discussion relevant around the globe? Is the story different in one region compared with another?

Mr. Davis: While the United States is closer to raising rates, other countries are operating in different stages of the economic cycle. Europe and Japan are both far from raising rates. Markets don't act in a coordinated fashion—some are going to accelerate and others are going to stabilize or decline, and that affects monetary policy in those markets. The idea that rates are going to rise globally and in a coordinated fashion is very unlikely given that the world's economies are not growing at an equal rate.

We also see a tale of two markets. There are the high-quality government markets such as the U.S. Treasury market, the U.S. mortgage market, German bunds, and Japanese JGBs. These very-high-quality government markets tend to be deep and liquid and trade in relatively large size very quickly. On the other hand, the global credit markets tend to trade less frequently, because there are many issues and many issuers.

Are you positioning Vanguard's bond funds in anticipation of investors pulling money out?

Mr. Davis: While bond market liquidity poses some challenges, large scale redemptions from bond mutual funds are unlikely when interest rates rise. Vanguard investors, in particular, tend to be long-term, buy-and-hold investors. We believe that our investors are not likely to overreact to a rate rise, although it may happen at the margin.

The majority of Vanguard's index portfolios are concentrated in highly liquid sectors and have significant holdings in U.S. Treasuries, mortgages, and investment-grade credit. We don't dedicate a great deal of assets to less liquid sectors of the market like high-yield or bank loans.

We also have very specific liquidity provisions within our funds to make sure we're able to meet our shareholders' redemptions should the need arise.

Would you speak a little more about Vanguard's risk management in the context of liquidity?

Mr. Davis: In a number of our actively managed bond funds, our investment policy incorporates core holdings of highly liquid securities. This approach enables us to hold liquid assets when we deem it appropriate and helps the portfolio management team manage cash flows. Additionally, our portfolios are highly diversified. If we have outflows, our ability to liquidate small portions is considerably easier for the market to digest compared with having to sell large blocks of a single issuer.

Our liquidity risk management is tailored to each individual fund and has multiple layers of protection. To build a liquidity risk management policy for every fund, we analyze each fund in terms of its holdings, the market liquidity of those holdings, past levels of peak redemption, composition of the fund's investors, and any other factors that may be relevant for that particular fund.

When a large client wants to redeem, we work with them in order to ensure the least amount of disruption to the portfolio. For example, we have the ability to "in-kind" large redemptions. If a client wants to sell a large amount out of a fund, we have the option to either give the client cash, which means selling securities to raise that cash, or give the client a slice of the portfolio's holdings, which the client could then sell. In some instances, we've done the selling for our clients, but in a separate account away from the fund to protect existing fund shareholders from the accompanying transaction costs.

I'd make one other point about liquidity management. We have a very experienced team and deep relationships with our trading counterparties. We believe our ability to source liquidity is a strategic advantage for us.

Are higher rates necessarily a bad thing?

Mr. Davis: No. Interest rates have been low for a long time now, and if you're an insurance company or an endowment, you want higher rates. If you're saving for retirement, you want to earn more money. It's as simple as that. You may take some short-term losses, but that market risk always exists.

So, cut through the noise. What is the message for bond investors?

Mr. Davis: Know your investment goals and stay the course. Don't let the day-to-day noise cause you to react. The key Vanguard tenets haven't changed and won't change during a rising rate environment.

Notes:

  • All investments, including a portfolio's current and future holdings, are subject to risk.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
  • High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.
  • Diversification does not ensure a profit or protect against a loss.