The Looming Risk In The Bond Market

October 5, 2015

by Robert Huebscher

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Lack of bond market liquidity has been the focus of recent reporting in the financial media. But one of the first to warn about that danger was Michael Aronstein, who said last week that the risks are clearer than ever. Mutual fund investors face the greatest peril.

Aronstein is president and chief executive officer of Marketfield Asset Management LLC and portfolio manager of the Marketfield Fund (MFLDX). He spoke September 29 at Bob Veres’ Insider Forum.

The crisis to unfold is driven by a liquidity mismatch, according to Aronstein. Mutual fund investors expect and demand daily liquidity on their holdings. Yet, in many cases, particularly in sectors of the bond market other than ultra-safe government assets, the underlying securities in those funds do not offer the same degree of liquidity.

“The beauty of the open-end mutual fund is daily liquidity,” he said. “The temptation is to enhance returns with underlying assets that don’t have day-to-day liquidity.”

“Every crisis since 1974, when my career began, has resulted from a mismatch of liquidity,” Aronstein said. “Assets for sale overwhelm their liquidity.”

Worse yet, Aronstein said the mutual fund market is a part of the financial system that “has never been tested.”

“The risks you have to worry about in this business are the ones without precedent,” he said.

The cause of the crisis

Excess monetary creation and “laxity” are the root of the problem, Aronstein said. The culprits include not only the quantitative easing (QE) policies of the Fed, but similar actions by the People’s Bank of China and the European Central Bank.

The result of those policies will be similar to the outcome of the housing market crisis, according to Aronstein. “Inappropriate access to credit across the globe has been used mainly for financial engineering, such as acquisitions and expansion of capacity,” he said.

The best example has been in energy sector, where companies have been able to raise unlimited amounts of money to drill for hydrocarbons, Aronstein said. Now that activity is “unsupportable.” Companies can no longer convert non-producing enterprises into income-generating businesses.

The fundamentals have been driven by an oversupply of generative assets, according to Aronstein, catalyzed by low interest rates. “There is nothing you can’t build out now,” he said. This oversupply happened in housing in 2005 and now the same situation exists in a “dozen industries,” he said.

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