Five years ago, the phrase 'maturity transformation' made investors shudder. Little wonder. Back in the credit bubble, short-term money was used to fund a mountain of long-term assets, such as mortgages, via the commercial paper market and repo world. But when the 2007 crisis hit, that short-term capital fled – and the maturity mismatch was revealed, creating a liquidity crunch.
It is a lesson that investors and policy makers should remember. Think, for a moment, about the corporate debt world. In recent weeks, the antics of the high-yield bond market have sparked a frenzy of investor debate. After all, the yield on high-yield bonds has recently tumbled to below 6 per cent, from nearly 16 per cent at the crisis peak, and issuance has surged dramatically.
Some bankers insist that this behaviour is benign, given that default rates remain low. And, as Melanie Mitchell of Kames High Yield Bond fund noted last week, the phrase 'high yield' covers many sectors and companies, some of which may well deserve low yields.
But others are uneasy. This week in Washington, for example, Robert Rubin, the former US Treasury secretary, warned that “excesses” seemed to be developing in the high-yield market, partly due to the huge provision of liquidity by central banks. Jeremy Stein, a Federal Reserve governor, was even more pointed last month, arguing that the swing in high-yield prices and surge in issuance signalled overheating*.
But while those tumbling yields have sparked debate, what has received less attention is the issue of maturity transformation. In previous decades, it was taken for granted that the type of people investing in high-yield debt or bank loans were mostly medium- to long-term investors, such as pension funds or life assurance groups, if not banks themselves.
But mutual funds and exchange traded funds have increasingly started gobbling up risky corporate debt on a significant scale. By late last year, assets in high-yield funds were running at about $350 billion, having almost doubled in three years. And, although those flows reversed slightly in February, money is now flooding into bank loan funds.
Indeed, industry data suggest $16 billion has moved into loan funds since last summer, with $5 billion of flows in February alone. Federal Reserve figures show that funds are now buying more than two-thirds of all corporate credit debt, up from a quarter in 2007.
This trend should come as no surprise. After all, many banks are reducing loans to risky corporate names because of new capital regulations – and investors are hunting for new places to put their funds. It is little wonder, then, that mutual funds and ETFs are stepping into this gap; to politicians, or credit-starved businesses, this could look benign.
But the rub is that high-yield and bank debt funds generally have no lock-up system: investors can withdraw their money at will. But company debt is medium-term in nature. And if anything causes a panic among retail investors, the money that has been backing all those corporate loans and bonds could vanish overnight – revealing another maturity mismatch, and funding gap.
Now don’t get me wrong: I am not forecasting that this flight will happen. Although there were four weeks of outflows from high-yield mutual funds in February – or after Mr Stein’s speech – some $820m flooded back in the first week of March; investors are (thankfully) not exiting this sector in panic now. So far, the short-term money that has gone into the corporate debt world does not appear to be associated with too much leverage; this makes the picture notably different from the asset-backed commercial paper market or repo sector in 2007.
But a key problem that confronts policy makers is that as money flicks between financial channels – say from repo into short-term funds – it is hard to track the maturity exposures or imbalances because the data are weak. “Ideally we would total all of the ways in which a given asset class is financed with short-term claims,” Mr Stein observed. “[But] I want to stress how hard it is to capture everything we’d like . . . If relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange traded funds, and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire sale-generating properties as short-term debt.”
Or, to put it another way, nobody really knows just how vulnerable the sector is to a sudden capital flight. In the meantime, we had all better hope that those corporate debt markets remain benign; and that investors do not entirely forget that 2007 lesson about maturity mismatches.
*Overheating in Credit Markets: Origins, Measurement, and Policy Responses, Jeremy Stein, February 2013, Federal Reserve Bank of St Louis.
Copyright The Financial Times 2013.