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 Vanguard Group, Guggenheim Investments and First Trust are among
U.S. fund companies that have lined up new bank guarantees or
expanded ones they already had, recent company filings show.
The measures come as the Federal Reserve and other U.S. regulators
express concern about the ability of fund managers to withstand a
wave of investor redemptions in the event of another financial
crisis. They have pointed particularly to fixed-income ETFs, which
tend to track less liquid markets such as high yield corporate bonds
or bank loans.
"You want to have measures in place in case there are high volumes
of redemption so you can meet those redemptions without severely
impacting the liquidity of the underlying securities," said Ryan
Issakainen, exchange-traded fund strategist at First Trust. The
company has increased a credit line it has set up to $80 million at
the end of last year, the most recent reporting period, from what
was originally a $20 million line in early 2013. The line is shared
by two of its ETFs and two mutual funds with a combined $645 million
in assets.
Under the Wall Street reform act known as Dodd-Frank, banks have
been shedding their bond inventories, resulting in less liquidity in
fixed-income markets. Because there are fewer bonds available for
trading, a huge selloff in the bond markets could worsen the effect
of a liquidity mismatch in bond ETFs.
Vanguard, the second-largest U.S. ETF provider, lined up its first
committed bank line of credit last year and now has a $2.89 billion
facility backed by multiple banks and accessible to all of
Vanguard's funds, covering some $3 trillion in assets, the
Pennsylvania-based fund company told Reuters. The new setup is to
"make sure that funds will be available in time of market stress
when the banks themselves may have liquidity concerns," Vanguard
said.
The issue for ETFs is this: When investors sell fund shares and
there aren't enough ETF buyers in the market, the ETF manager in
many cases will need to immediately sell shares of the underlying
securities in the fund to meet those redemptions. But a sudden
selloff of an ETF in an illiquid market could cause the manager to
have to dump those securities at any price, causing their share
prices to collapse. With a line of credit, fund managers could
instead meet redemptions and take their time to sell some
securities.
"These funds offer daily or even intraday liquidity to investors
while holding assets that are hard to sell immediately, thus making
the funds vulnerable to liquidity risk," U.S. Federal Reserve Vice
Chair Stanley Fischer said in a speech in March in Germany, pointing
directly to ETFs and saying they have mushroomed in size while
tracking indexes of "relatively illiquid" assets.
That is all exacerbated because investors have been pouring money
into bond ETFs, while banks, under regulatory pressure to limit
their own holdings, have been slashing their bond inventories.
Growth in fixed-income ETFs also means there are now more products
tied to corners of the bond market previously untapped by ETFs.
Assets in U.S.-listed fixed-income ETFs are up nearly six-fold since
2008, to $335.7 billion at the end of April, according to Thomson
Reuters Lipper data.
With overall fixed-income ETF growth has come expansion in some
esoteric corners of the bond market. Assets in loan ETFs, for
example, have grown almost five-fold over the past three years to $7
billion at the end of April. Many of these funds weren't in
existence during financial crisis that shook global markets in 2008
and haven't been tested by a widespread run.
BOLSTERING CREDIT LINES
Like paying for insurance, maintaining these liquidity backstops
comes at a cost.
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Banks facing their own reserve requirements against these lines are
charging commitment fees that can range from 0.06 percent to 0.15
percent, according to company filings. If a line is actually drawn
upon, there would be additional interest charged on any amount
borrowed. In many cases, these costs are included in the ETF's
annual expense ratio, and borne by the funds' investors.
Borrowing costs vary from firm to firm, but they are typically
charged interest at a rate equal to the higher of the federal funds
rate or the adjusted London interbank offered rate plus an agreed
upon spread.
Most fund managers cite the expansion of their credit facilities as
commensurate with the growth in assets of their funds. But they are
also able to point to them as ways to head off regulator concerns at
a time when asset managers have been the subject of increased
scrutiny about whether or not they should be classified as
"systemically important financial institutions," a tag that would
involve more regulation.
Vanguard, for example, referenced its committed credit line in a
letter to the Financial Stability Oversight Council in March, noting
it was one of the measures it has in place for liquidity risk
management.
BlackRock Inc, the world's largest ETF manager, hasn't opened lines
of credit for its bond funds because it doesn't trade in the less
liquid corners of the bond market, but it has opened a line of
credit against its some of its emerging market stock ETFs as "a
source of cash to be used to facilitate settlement requirements
associated with trading in smaller markets," spokeswoman Melissa
Garville said.
State Street Corp, the third biggest ETF provider after BlackRock
and Vanguard, and Invesco Ltd's PowerShares, the fourth-biggest,
have credit lines set up for their respective senior loan ETFs. For
State Street, its senior loan ETF alone has exclusive access to $100
million of the total $300 million credit facility the fund company
has in place.
Other ETF firms that have expanded their credit lines include New
York-based Guggenheim and Dallas-based Highland Capital. Highland
increased its credit line six-fold to $150 million last October in
part because of one big investor who "wanted to get a little more
comfort" that the fund would be able to meet a potentially large
redemption, said Ethan Powell, the firm's chief product strategist.
"In order to accommodate that investor effectively, we upsized the
size of the facility," Powell said. "We don't anticipate drawing on
it, but it really serves as more of a security blanket."
(Reporting by Ashley Lau in New York and Michael Flaherty in
Washington; editing by Linda Stern and John Pickering)
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