More Problems for Bond Funds and ETFs
If you participate in a 401k, regulations forbid you from owning individual bonds. Your only option is to buy a pooled product like a bond fund or ETF.
That’s just the way Wall Street wanted it.
In a Wall Street Journal interview in 2017, the so-called father of the 401k, Ted Benna, now says he “helped open the door for Wall Street to make even more money than they were already making.” The explosive growth in 401k’s has been a boom for the financial industry, helped by the fees they earn on bond funds and ETF’s.
But there may be consequences to the exclusion of owning individual bonds in your 401k. What happens when there is a panic selling in the bond market?
In a pooled product like a bond fund, it could be the case that the liquidity of the fund is greater than the liquidity of the underlying bonds it owns. This gives a false impression that the fund can raise cash relatively quickly.
So, if there is panic-selling of the fund’s shares, the fund’s manager may have to accept severely discounted prices on the bonds sold to cover redemptions. This can put fund owners who do not sell in a disadvantaged position.
That very risk came true recently when bond fund prices collapsed in a wave of selling triggered by the pandemic.
In a March 1 speech, Fed Governor Lael Brainard summarized the issue by stating, “the associated forced sales of fund assets contributed to a sharp deterioration in fixed-income market liquidity that necessitated additional emergency interventions by the Federal Reserve.”
In response, policymakers are now debating this risk to the bond market and how best to respond. For her part, in the same March 1 speech, Brainard suggested the concept of Swing Pricing would be a potential solution to the problem.
What is Swing Pricing?
Simply put, Swing Pricing is a penalty paid by those panic sellers that have sold their position into an illiquid market, potentially harming those that stay behind. The idea would allow bond funds to pass along the losses incurred by panic sellers.
The whole thing sounds good on the surface while also raising several complex issues around the definition of “panic” and allowed amounts charged for a withdrawal. The intention of swing pricing is good, but the implementation is unlikely to work in a manner that satisfies anyone. It would just be too complex.
What would be a far easier solution?
It doesn’t take a genius to see that the best solution for these circumstances would be to allow 401k’s to invest in individual bonds. Because these are retirement funds, those that buy individual bonds for a portfolio are more likely to simply hold the bond until maturity.
In my opinion, when investors own individual bonds, there is less pressure to succumb to a panic in the market. Most recognize that taking a loss makes no sense if the original purpose for owning it has not changed.
Individual bonds are ideal investments for retirement accounts. Investors approaching retirement often look for an investment that provides income and a future principal return. Those terms are what make individual bonds so attractive.
So, it seems to me that instead of creating mounds of rules and regulations to prevent panic selling in the bond market, regulators should allow investors to buy individual bonds in their 401k accounts.
Of course, we know that will never happen. The power of the financial services lobby, drunk on the fees from bond funds, would never agree to such a simple solution. Doing so would likely result in massive withdrawals from bond funds.
With that in mind, we recommend that as soon as you are able, you roll your 401k over into an IRA. Once the money is in an IRA, you will have access to the individual bond market and the opportunity to own your own bonds.
If you have a 401k and would like to learn more about a rollover, please give me a call. We can discuss helping you build a customized bond portfolio that fits your needs and objectives.
I look forward to hearing from you!