The EconomistJuly 22nd 2017 Finance and economics 592
G
OOD generals know that the next war
will be fought with different weap-
ons and tactics from the last. Similarly, fi-
nancial regulators are right to worry that
the next crisis may not resemble the credit
crunch of 2007-08.
The last crisis arose from the interac-
tion between the market for mortgage-
backed securities and the banking sys-
tem. As investors became unsure of the
banks’ exposure to bad debts, they cut
back on their lending to the sector, caus-
ing a liquidity squeeze. Since then, central
banks have insisted thatcommercial
banks improve their capital ratios to en-
sure they are less vulnerable.
Might the next crisis originate not in
the banking system, but in the bond mar-
ket? Thatis the subject ofa new paper*
from the Bank ofEngland. The worry cen-
tres on the “liquidity mismatch” between
mutual funds, which offer instant re-
demption to their clients, and the cor-
porate-bond market, where many securi-
ties may be hard to trade in a crisis. The
danger is that forced selling, to return
money to investors, leads to big falls in
bond prices, creating a feedback loop.
If that concern seems fanciful, think
back to the summer of 2016, when British
mutual propertyfunds had to suspend re-
demptions in the wake of the EUreferen-
dum vote. Fund managers simply could
not sell properties fast enough to pay off
their investors.
The corporate-bond market is a partic-
ular concern because it is much less liquid
than the equities market. That liquidity
has fallen in recent years, because banks
have become less willing to act as market-
makers. This reluctance is rooted in the
regulationsimposed afterthe lastcrisis,
which require banks to hold more capital.
The Bank of England’s study focused
on European mutual funds that own in-vestment-grade bonds (the safest catego-
ry). Since 2005, the worst month for re-
demptions in this sector occurred in
October 2008, when outflows reached the
equivalent of 1% of assets under manage-
ment each week. The sell-off was accom-
panied by a rise in bond spreads—the gap
between the yield on investment-grade
bonds and that on government debt—of
around a percentage point.
Some of that increase was obviously
caused by a deterioration in the economy—
investors realised that bond issuers were
more likely to default. But the bank reckons
that around half the shift was the result of a
decline in liquidity. In other words, bond
investors demanded a higher yield to com-
pensate them for the difficulty they might
face in selling their holdings.
The bank reckons that, if a 1% outflow of
mutual-fund assets happened today, then
European investment-grade spreads
would rise, for liquidity reasons alone, by
around four-tenths of a percentage point.
That may not sound much, but it is around
a third of the average spread since 2000.
What if the sell-off is greater than it was
in 2008? After all, near-zero rates on cashmust have pushed a lot of investors into
corporate-bond funds in recent years.
Some of those investors may be using
bond funds as “rainy day” money and
will thus be reluctant to sit tight if their
savings are losing value.
Others could step in to buy the bonds.
Long-term holders like pension funds and
insurance companies are obvious candi-
dates to do so, although they tend to be
slow to react. Hedge funds are more nim-
ble bargain-hunters but they often de-
pend on financing from the banks, and
that may not be available in a crisis.
Finally, the banks themselves could
step in, but they face capital charges on
their market-making activities. The mo-
ment could come, the bank suggests,
when “dealers reach the limit of their ca-
pacity to absorb those asset sales”. This
would be the “market-breaking point”.
And that stage could be reached when re-
demptions equal 1.3% of net assets of cor-
porate-bond funds—in other words, only
30% higher than during the 2008 crisis.
A sell-off in corporate bonds ought not
to be as damaging asthe mortgage-related
crisis of2008. Investors don’t tend to use
borrowed money to buy such bonds, and
the big asset-management companies
don’t back funds with their own capital.
Corporate bonds also comprise only a
small part of most portfolios. But it could
still be traumatic if bond funds need to be
suspended. That could undermine retail
investors’ confidence in the liquidity of
the mutual funds on which many depend
for their retirement income. The bank is
right to be alert to the risks.Buttonwood The bonds that break
A sell-off of corporate bonds could lead to a breaking-point for the market..............................................................
* “Simulating stress across the financial system: the
resilience of corporate-bond markets and the role of
investment funds”, Financial Stability Paper No 42Economist.com/blogs/buttonwoodhigh in private equity. In a recent analysis
of over 700 firms, Josh Lerner and Victoria
Ivashina of Harvard Business School
found thatcompensation of partners in
the industry wasinextricably tied, not to
individual investment success, but rather
to whether they were there at a firm’s birth.
The average founder receives nearly 20% of
all profits from “carried interest” and owns
a 31% stake in his firm; a non-founding se-
nior partner gets on average only 11% of
profits and owns less than 14% of the firm.
Such unequal arrangements can make
a transition trickier. Reallocating profits or
transferring outsize ownership stakes toother partners risks internal bickering. In
2010 Justin Wender, the anointed succes-
sor of John Castle, the founder of an Amer-
ican firm called Castle Harlan, left amid a
dispute about “future ownership”. Friction
over succession and profit-sharing at Char-
terhouse, a British firm, came to light in
2014 in the form of a lawsuit by a disgrun-
tled former partner, who alleged, among
other things, that the firm tried to force him
to sell his stake at an excessively low price.
Charterhouse won the case.
Mr Lerner worries that a growing trend
of exiting founders selling their stakes ex-
ternally causes other problems, particular-ly for private firms. If such firms are no lon-
ger in the hands of those who make the
profits, for example, that may weaken the
alignment of interests that has driven
much of the industry’s success.
All these concerns will come to a head
when increasing numbers of founders step
back. Large firms like KKR have diverse
businesses and big teams of executives;
smaller counterparts, where power is con-
centrated with individual founders, may
have more trouble adjusting. All the more
reason to followKKR’s lead on leadership.
Success and succession will become ever
more intertwined. 7