The IMF’s Warning to Mutual Fund Holders

The International Monetary Fund (IMF) issued a rare warning to U.S. mutual fund investors about the risks associated with high-yield bonds.

In a Global Financial Stability Report, the organization reported that many mutual funds have taken large positions in high-yield bonds issued by risky companies operating in the U.S. and emerging markets around the world. The era of extraordinary central bank activism has provided plenty of liquidity in the past, but investors may have false senses of security, and these bonds could become difficult to sell during a market reversal.

“Even seemingly plentiful market liquidity can suddenly evaporate and lead to systemic financial disruptions,” stated the report’s authors in their warning to mutual fund investors. “Changes in market structures – including growing bond holdings by mutual funds and a higher concentration of holdings – appear to have increased the fragility of liquidity. At the same time, the proliferation of small bond issuances has likely lowered liquidity in the bond markets and helped build up liquidity mismatches in investment funds.”

Emerging market bonds were highlighted as especially large risks for investors, following concerns about China’s economy.

The IMF highlighted China and Turkey as two economies that experienced the largest increases in corporate debt since 2007, with China’s debt jumping 27%, and Turkey’s debt increasing 24% over the time frame. On the whole, corporate debts in emerging markets surged to nearly $20 trillion in 2014 from less than $5 trillion in 2004. Mutual funds have been aggressive buyers of these bonds, given investor appetite for yield amid record-low interest rates.

Dollar-denominated bonds have been the fastest-growing subset of emerging market bond issuance, rising to $855 billion last year from $163 billion in 2003. With the U.S. looking to raise interest rates in December, the interest payments on these dollar-denominated bonds could become more expensive for companies generating revenue in foreign currencies. These dynamics could lead to a flight of capital away from these bonds.

Investors may want to take a closer look at their mutual funds to see if they have any potentially dangerous exposures to these high-yield bonds.

Mutual fund holdings regularly are disclosed in Form N-Q and Form N-CSR filings with the SEC, which are accessible using the SEC’s EDGAR database. Since the disclosures are made quarterly and funds have a 60-day window to make the filings, the information disclosed isn’t especially timely in nature, but it does provide a good idea of a fund’s target asset classes. These filings also provide details into sector diversification and outline risk factors for investors to consider.

In addition to retrospectively looking at a mutual fund’s quarterly holdings, investors should carefully read through their prospectuses to ensure high-yield bonds don’t represent disproportionate levels of their overall focuses. Investors also may find some mutual funds are named in such a way that their focuses are obvious, such as the Buffalo High Yield Fund (BUFHX), which means that reading through prospectuses may not even be necessary.

The IMF issued a rare warning to mutual fund investors, saying that high-yield bonds could see liquidity dry up, which could create potential risks. In emerging markets, these risks particularly are acute, given the high amount of dollar-denominated debts, which could become difficult to service in a rising rate environment that could boost the dollar’s value relative to foreign currencies where these companies are generating revenue.

Investors should take the time to assess their portfolios for risk right now by looking at Forms N-Q and N-CSR as well as prospectuses to see what they might consider selling.