Recently there has been talk in the news media that the government might impose an exit fee on bond mutual funds to stop bond holders from selling during a panic. The fear is that rising rates would drive investors out of bonds creating a panic that would make prices go down. If such a regulation was created then investors would sell off their holdings before the regulations were set to take effect, thus negating the benefit of the regulations.
Yellen said last week at the Federal Reserve press conference that she didn’t think such an idea would be adopted. If these regulations were adopted it would raise market interest rates or at least raise the spread over Treasuries for all other debts.
This type of problem is the same as the problem of how to deal with bonds during a period of rising rates. When the economy recovers rates rise and this makes bond prices go down. Thus one needs to maintain a low duration bond portfolio so as to reduce the risk of being hurt by rising rates. The news media mentioned that if regulations imposing an exit fee were created that this would only apply to larger balances, so presumably one solution would be to diversify into lots of small holdings across many different mutual funds and ETF’s. Another solution would be to allocate more into Treasuries and then hold them directly instead of using a mutual fund. This is because individual Treasuries are traded in a very deep liquid market with low spreads, unlike other bonds.
Perhaps investors could shift to a barbell strategy (for the bond part of portfolio) of owning both Treasuries that could be cheaply and easily sold and illiquid “collector’s item’s” type of bonds that are best held to maturity such as a 30 year Muni issued by an obscure high yielding agency. Such a barbell strategy would have to be carefully thought through because the illiquid markets would have higher hidden costs such as the dealer’s bid-ask spread and the risk that no one will buy it if the owner needs some quick cash. If one seeks to own an illiquid bond they need to make a plan to hold it for the full 30 year term and thus plan on earmarking other assets to be used to raise cash during a crash.
Probably the most reliable strategy if this proposal is ever implemented would be to reallocate bonds to Treasuries rather than get stuck with illiquid bonds during a period of rising rates. Despite the potential for rates to remain low for a surprisingly long period, eventually the work force, including the discouraged unemployed will have learned new skills, moved to where the demand for labor is high and finally gotten good jobs and thus inflation will eventually return.
The basic purpose of owning bonds is to diversify from risk-on assets so that one can sell investment grade bonds during a risk-on asset crash and then use the cash to buy risk-on assets at a discount. This would not be practical for illiquid obscure bonds.
If restrictions on selling bonds have exemptions for small holders then what can a large investor do? If a large investor has $100 million of which half are allocated to bonds they might buy $25 million in directly owned Treasuries and then allocate $25 million to buying an offshore financial company such as a bank which would create and hold directly owned loans instead of bonds. Of course they need to disclose to the IRS that they own a foreign based company but they would still be free to have their bank trade positions in loans and bonds as long as no transactions were done in the U.S. The key is in this situation they would merely be a stockholder in a company that invests in financial assets.
An alternative for someone with a large fortune might be to buy a Cash Value Life Insurance policy which would invest in an offshore portfolio of individual bonds. If the insurance is issued by a foreign company the taxpayer must disclose it to the IRS and pay the IRS a foreign insurance premium tax. A smaller premium tax is owed if the company is domestic. During a stock crash a portfolio of investment grade bonds would have a lower probability of decline in value than risk-on assets so they could be sold and used to buy stocks during a crash.
Using Cash Value insurance to hold wealth requires payment of fees to the insurance company, so the taxes saved might be offset by the insurance company’s fees unless one shops carefully for a low fee policy. If someone has a large fortune they could buy their own insurance company and then buy a policy from it, thus saving some fees, but even then there are many overhead costs that they would incur.
Investors need independent financial advice about the risks of bonds. I wrote an article about bonds during rising rates. “Bonds did OK in a rising rate era but circumstances may change”.