All Out May 12th: The Debt Ceiling and Getting Out First
This week we’re talking about a couple of things we’ve been thinking over the past few weeks. Our apologies for not writing last week, but we were attending an event hosted by our great friends IDC Network (we’re not blaming you, just that we were too busy to sit down and write anything of substance).
Something we want to point out is that many of you have expressed your liking of our writing. We want to try to make this more interactive and we love hearing your feedback. If you want us to write about a specific topic, have any questions about what we do or anything finance related, please don’t hesitate to reach out! You can simply hit reply to this e-mail and we’ll get a copy.
Debt Ceiling Standoff
We still don’t know what’s going to happen with the whole debt ceiling debate. In theory the Treasury has already reached the total amount of debt it can issue. However, the Treasury still has plenty of cash in it’s general account from which they can make payments from. That’s why there still hasn’t been any panic in financial markets, Treasury still has roughly $197.67 billion in the account; which will supposedly float them until around early June (Bloomberg reported on Thursday that they only had $68.3B which is the lowest since 2021). We read something over the weekend a couple of things that put this in perspective. This from Eric Peters “wknd notes”:
“But here we are, May 2023, with a $31.4 trln national debt. It does not really matter; any crisis that can be ended with the swipe of a pen lacks substance.”
“It is impossible to predict with certainty the exact date when global investors will lose faith in the US government’s ability to service this colossal and growing debt with anything other than debased dollars. This is the only date that truly matters. In a nation unwilling to endure prolonged austerity, the only credible way to push that date into the distant future requires technological advance that generates dramatic productivity gains. And in the meantime, any serious group of political leaders would coordinate every conceivable activity to promote such progress and stop distracting us with absurd crises of their own creation.”
His point is that the absolute number of the debt doesn’t really matter. The US can print however much money it wants, there is no limit. It could print $1 trillion tomorrow, $10 trillion, $1,000 trillion; there’s no physical or digital limit. The limit comes with inflation. If the US were to print $100 trillion tomorrow surely the dollar would lose value relative to other currencies since there would be so much in circulation. So is the debt a problem? Sure it can be, but it isn’t now. And it certainly isn’t one if it can be solved by simply a “swipe of a pen”. We’ll see how down to the wire it goes, but it will get resolved, it has to.
Liquidity and Getting Out First
The other day we were speaking with a client about liquidity. Specifically we were talking about liquidity terms in different funds. Some hedge funds only allow you to redeem your money after a certain period has lapsed, others only allow up to X% to be redeemed per month/quarter/etc. So why is this done? Depending on the type of fund it can be done for several reasons. Funds that invest in illiquid securities don’t want to be in a position in which they have to have to dump their assets to meet redemptions. This is the case with BREIT that has 2% monthly withdrawal limit and a 5% quarterly limit (and they’ve been restricting withdrawals for the last 6 months). The fund invests in real estate and offers monthly liquidity. So if many of their investors wanted to withdraw their money, they would have to fire sell their assets just to meet redemption requests.
Other funds limit withdrawals because strategies may take time to play out. If a fund is trading a certain arbitrage strategy in which it buys one security and sells another, they don’t want to be in a position in which they have to sell out of their position at the worst possible time because some investor needs their money.
The reasoning behind lockups in many cases, not all, is to protect investors. If a fund has to fire sell it’s assets, then the non-redeeming investors (those who stayed invested) will be left with assets that are worth less. This is most clearly seen in fixed income mutual funds. Fixed income markets are much more iliquid than equity markets. There are tens of thousands of bonds in the US and many (probably most) of them don’t trade every day. There is no centralized exchange in which transactions take place, to trade many bonds you have to physically call a bank or broker and see if they want to buy your bond or if they have the bond you’re trying to buy in inventory. It’s a very archaic system full of inefficiencies. This means that liquidity for many bonds is very poor and can be hard to gauge. Typically lower rated, “junkier” bonds are more illiquid and harder to trade than higher quality bonds (this is partly because many investors are restricted from trading junk bonds, amongst other reasons).
When you invest in a mutual fund, you send the company $100 and they go out and they buy $100 worth of bonds. Conversely if you withdraw $100, the company has to go out and sell $100 worth of bonds to pay you back (most funds have some cash to deal with small transactions but lets ignore that for simplicity). So if a large investor wants to withdraw their money, the fund will probably start off by selling the most liquid (and highest quality) bonds first. This is because it will have the least impact on the pricing of the fund. The more liquid something is, the easier it is to trade; which means that you’ll get a better price for it.
Probably an example will market his point clearer. Let’s say a fund has $100 invested in it, $50 of that being in high quality, liquid bonds, and $50 being in junk bonds which are illiquid. There’s a 50/50 split between quality and junk. Now let’s say an investor wants to redeem $30 from the fund. The manager will probably go out and sell $30 worth of the quality, liquid bonds first. So the investors that are left in the fund will now own a portfolio which is more illiquid and which is 71% junk ($50/$70), as opposed to 50% before. If another $30 is going to be withdrawn then remaining investors would be left with 100% junk portfolio which is even more iliquid. So when they try to get their money out the remaining $40 might in reality be worth $30 after the bonds are sold (you may think a bond is worth $40, but may only be able to sell it at $30, in the end something is worth whatever you can sell it for).
This is made even worse in the sense that if you think there will be large redemptions from these funds, then the rational thing to do is to try to withdraw your money before these large redemptions hit. Since if you get out first chances are you will get most of your money back and not be stuck with a bunch of illiquid positions which you’re not sure how much they’re worth. So redemption limits are in place, in large part, to protect investors from panic selling at the worst possible time and affecting other investors which have steady hands (💎🤲). Also trading isn’t free, so the more you have investors coming in and out, the more costs the funds will incur. And these costs are borne by all investors, not just the redeeming investors.
On a side note, this is one of the many benefits of ETFs over mutual funds. Since ETFs don’t actually go out and buy or sell any positions, then if an ETF investor panics, they are going to take the loss themselves and not affect the other investors in the fund. How an ETF works is a topic for another day.
