Volcker Rule has been a game-changer with bond liquidity.
Jared Dillian is the editor and publisher of The Daily Dirtnap, a market newsletter for investment professionals, and the author of “Street Freak: Money and Madness at Lehman Brothers.”
The unraveling of PIMCO was front-page news in the Wall Street Journal for the better part of two weeks. And why not? It has all the elements of a great Journal story: big personalities, big bonuses, he said/she said, all kinds of drama. The reporting really was great, and it gave people an up-close look at the inner workings and hidden mechanisms of the biggest bond manager in the world.
People clearly did not like what they saw. The redemptions have been going on for a year, but they massively accelerated upon news of the departure of Bill Gross from PIMCO.
In fairness to PIMCO, every large organization has its own peculiar culture, and every large organization is dysfunctional in some way. But when it involves $2 trillion in assets and the fighting spills out into the open, it doesn’t give people a warm, fuzzy feeling about the care with which the assets are being managed.
So if I am a pension fund manager and I have, say, $15 billion with PIMCO, and all this drama is getting played out in the news, I kind of feel like I have a fiduciary responsibility to consider other asset managers.
It is also an open secret that whenever you have big redemptions out of a mutual fund (or an ETF, or closed-end fund), there are big ramifications in terms of liquidity.
When you redeem shares in a mutual fund, the fund is forced to sell down positions to raise cash to meet redemptions. When you’re talking about redemptions on the order of tens of billions or more, you can potentially disrupt markets that may not be able to accommodate those kinds of demands for liquidity. For example, it was well known that PIMCO’s Total Return Fund, which Gross managed, had a sizable Mexico position.
This liquidity issue at PIMCO is part of a much larger discussion about bond market liquidity: There is none. The ability to move large quantities of bonds has declined significantly since the passage of Dodd-Frank, with the Volcker Rule. And issuance has exploded, leaving asset managers, particularly mutual funds, stuffed with huge positions in securities they will find difficult or impossible to sell.
Volcker Rule Hampers Liquidity
For review, the Volcker Rule prohibits proprietary trading by systemically important institutions, and a lot of what a corporate bond market maker does constitutes proprietary trading, in the eyes of the regulators.
For example, if I am a corporate bond trader at bank ABC, and someone sells me $10 million of bond XYZ, it’s often difficult to turn around and sell out $10 million of bond XYZ, even at a loss. So maybe I have an idea that bond LMNO is going to underperform bond XYZ, so I sell that instead, and keep the hedged position until I’m able to unwind it.