Bond funds may be exposing customers and the financial system to more risk than some investors realize as money managers seek higher returns in less liquid assets, the International Monetary Fund said in a report recommending improved oversight.

“The role of fixed-income funds, which entail larger contagion risks than traditional equity investment, has expanded considerably,” the IMF said Wednesday in a chapter on asset managers in its latest Global Financial Stability Report.

The 2010 Dodd-Frank law’s curbs on proprietary trading in the U.S., known as the Volcker Rule, has reduced liquidity and raised the importance of mutual funds and exchange-traded funds in the bond market. The Washington-based lender said that’s made more products available to “less sophisticated investors.”

While the U.S. mutual fund industry’s regulation regime is based primarily on disclosure, the IMF proposed enhancing “liquidity rules, the definition of liquid assets, investment restrictions, and reporting and disclosure rules.” Not enough is known about the use of leverage and derivatives, said Gaston Gelos, chief of the IMF division that worked on the chapter.

Globally, asset managers oversee $76 trillion — the equivalent of world gross domestic product, the IMF said. The report brings the institution into a debate in the U.S. and elsewhere about whether the asset-management industry — from common mutual funds to ETFs — needs closer scrutiny.

“We know relatively little about leverage — even for plain vanilla mutual funds we don’t have much information,” Gelos said in an interview. “In particular, we don’t have much information about the derivatives, so that’s one area where more disclosure would be helpful.”

At the same time, central banks’ low interest-rate policies of recent years may be spurring a growing number of investors to flock to higher-yielding, riskier securities, the IMF said in the report.

“The prolonged period of low interest rates in advanced economies has resulted in a search for yield, which has led funds to invest in less-liquid assets,” it said.

U.S. Federal Reserve officials are monitoring the situation.

“Fixed-income markets are much less liquid than they were and that does raise concerns,” said Fed Governor Jerome Powell, answering audience questions after a speech Wednesday in New York. “The answer isn’t obvious, but it does raise significant questions.”

 

Herding Concerns

The rise in herding, when asset managers invest in certain assets mainly because others are doing so, “coincides with the adoption of unconventional monetary policies in the United States, and could be related to an accentuated search for yield by mutual funds,” the IMF said.

While asset managers act as a “spare tire” in world’s financial system, providing financing even when banks are distressed, the industry raises risks that call for changes in regulated and oversight, the IMF said.

“Easy redemption options can create risks of runs because of the presence of a first-mover advantage,” the IMF said. “The destabilization of prices in certain asset segments (particularly bonds) can affect other parts of the financial system through funding markets and balance sheet and collateral channels.”

The effects of large-scale sales by funds could spread unevenly, hurting emerging markets most even if the funds are domiciled in advanced economies, according to the report.

When it comes to threat that the asset managers could pose to the global financial system, the largest companies aren’t necessarily the most dangerous. “The investment focus appears to be relatively more important than size when gauging systemic risk,” the IMF said.

That line of IMF research echoes U.S. regulators, who in 2013 discussed whether BlackRock Inc. and Fidelity Investments should be labeled systemically important to the financial system and subjected to tougher oversight and strict capital requirements. The focus has since shifted to asset managers’ products and activities rather than labeling an individual firm as systemically important.

The mutual-fund industry is dominated by the U.S., home to 49 percent of the companies. About a third are based in Europe while, among emerging markets, Brazil has the largest concentration, according to the IMF.

 

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