Lesson 22 of 25 · 7 min

Bond and credit funds, March 2020: why the liquid holdings sold first

In a cash squeeze the price that falls is the one that could be traded, not the one that was risky.

In March 2020 something happened that looks wrong at first glance: the safest and most liquid instruments sold off alongside the riskiest ones. The explanation is not a change of view about safety. It is that a fund meeting redemptions sells what it can sell, and what it can sell is by definition the liquid part.

Bond and credit funds faced redemptions reported at record levels in the weeks to late March 2020. Meanwhile the cost of trading corporate and structured credit widened sharply, and exchange-traded credit funds traded at discounts of several percent to their stated asset values — a real-time price for immediate liquidity that the underlying bond market was not quoting at all. No individual fund is named; this was a category-wide event.

Faced with a cash requirement, a manager can sell government bonds at a fraction of a basis point of cost, or high-yield credit at a few percent. The cheaper route is the liquid one, which is why liquid assets are the ones that get sold and therefore the ones whose prices fall first. Selling pressure in a liquidity event is ordered by transaction cost, not by risk.

The residual effect matters as much. After the liquid sleeve has funded the redemptions, the remaining portfolio is more concentrated in exactly the exposures the fund was struggling to price, so its capacity to meet the next wave is lower. Central bank facilities announced in late March 2020 reversed the flow, which is why the episode is remembered as brief rather than as instructive.

In a liquidity event, price moves rank by how easily something can be sold. That ordering is the opposite of the one a risk report implies.

Key terms

Transaction cost: The round-trip cost of trading an asset, including the bid-offer spread and market impact. It decides what gets sold first under pressure.
Discount to net asset value: An exchange-traded fund's price below the stated value of its holdings. In stress it is a live quote for immediacy that the underlying market is not providing.
Cash-raising ladder: The order in which a manager sells to meet redemptions: cash, then the cheapest to trade, then the rest. Each rung leaves the fund less liquid.

Worked example

Two routes to the same cash

Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. A fund of 900,000 holding 216,000 of government bonds and 414,000 of high-yield credit, needing 72,000 of cash against trading costs of 0.04 percent and 3.1 percent respectively.

Cost of raising it in government bonds: 28.80
Cost of raising it in high-yield credit: 2,232.00
Ratio between the two routes: 77.5x
Government bond share after the cheap route: 17.4%
High-yield share after the cheap route: 50.0%

The cheap route is 77.5 times cheaper and it raises the high-yield share by 4 points. Every manager in the category faces the same two numbers on the same morning.

Check yourself

A fund must raise 51,200 of cash. Government bonds cost 0.05 percent to sell and high-yield credit costs 2.7 percent. What is the cost of each route, and which assets fall in price as a result?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.