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IMF: Lurking Issue in Bond Fund use of Derivatives

The IMF suggests that limited disclosure by funds about the risks of derivatives has left “investors and policymakers in the dark on a key issue for financial stability.” In a recent blog post, the organization argues that while derivatives can be a useful tool, “[w]hen used to speculate, they can be bad news given the potential for big losses when bets go wrong.” The post notes that “mutual funds accounting for about 2/3 of the assets in our sample disclose derivatives leverage ranging from 100 percent to 1000 percent of net asset value in their annual reports.” The IMF suggests that the recent three-year “period of both low interest rates and low volatility [] may mask the risks of leverage.” It conducted an analysis finding that a portion of bond funds are both highly levered and highly sensitive to fixed-income benchmark returns, a “combination [that] raises a risk that losses from highly leveraged derivatives could accelerate in a scenario where market volatility and U.S. bond yields suddenly rise” resulting in a flood of redemptions spiraling into fire sales.

Assessing these risks is difficult due to a lack of data, according to the IMF. It calls the recent SEC proposal on derivatives “a welcome step” and suggests that “detailed and globally consistent reporting standards across the asset management industry would give regulators the data necessary to locate and measure the extent of leverage risks.” It suggests that these standards should provide sufficient information for regulators to understand funds’ market moves in order to properly assess risk.