How safe is your retirement from a financial market collapse? While six years of booming asset prices have lulled investors into a sense of complacency, a hidden risk could spark a bond and stock market crash in 2015.
At least, that is according to billionaire investor Bill Gross. In a blog post published Tuesday, June 30th, the money maven warned hidden risks are building up in the financial system. Even investors in so-called ‘safe’ asset classes like bonds and other fixed-income instruments could be wiped out. (Source: Janus Capital Group, June 30, 2015.)
“Mutual funds, hedge funds, and ETFs, are part of the ‘shadow banking system’ where these modern ‘banks’ are not required to maintain reserves or even emergency levels of cash,” the co-founder and former head of PIMCO wrote.
He continued, “Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the ‘market’ selling to itself with the Federal Reserve severely limited in its ability to provide assistance.”
Since 2005, trading turnover in the investment grade bond market has declined by 35%. For the high-yield market, the decline was 55%. “Financial regulators have ample cause to wonder if the phrase ‘run on the bank’ could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks.”
The idea is simple. When an investor wants to redeem a fund, the fund needs to get cash to pay the investor. It could either pay with cash on hand, or sell some of the securities it holds. Since funds are not as regulated as the banks, they do not keep much cash.
When a large amount of investors want to redeem their investments, the fund would not have enough cash and needs to sell the underlying securities. These could generate massive sell-offs in both equities and fixed-income markets.
Gross is also worried a booming stock market has made investors complacent: “Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers’ hands are tied to perform their historical function of buyer of last resort. It’s then that liquidity will be tested.”
How does Gross recommend investors position themselves? “Hold an appropriate amount of cash,” he wrote, “so that panic selling for you is off the table.”