Fearing a bond fund run, Fed is considering exit fee

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Could investors be charged an additional fee for selling shares in their bond mutual fund?

That is what financial adviser James Sanford fears may be in store for the investing public.

In recent weeks, Mr. Sanford has become an outspoken critic of what he has described as the Federal Reserve “changing the rules at half-time.” He said the Fed is pushing for an exit fee on bond mutual funds because it is growing more concerned about a “run” on bond funds that could occur as soon as interest rates — which are now around zero percent — begin to move up.

As interest rates rise, the value of bond mutual funds will fall. That may provoke an episode of selling that could wreak havoc on the bond market and have ripple effects on the broader economy, he said.

“Imposing more fees on individual investors, in a world where it’s very hard to earn any interest at all, takes more money out of their pockets,” said Mr. Sanford, founder of Sag Harbor Advisors in Sag Harbor, N.Y. “It’s unfair. Investors bought these funds unaware that there could be exit fees, so I find this to be a huge contractual violation.”

The issue of imposing an exit fee on bond mutual funds has been up for discussion in recent weeks, according to the Financial Times.

In June, the newspaper reported, “Fed discussions have taken place at a senior level but have not yet developed into formal policy, according to people familiar with the matter. … exit fees would seek to discourage retail investors from withdrawing funds, thereby making their claims less liquid and making a fire sale of the assets more unlikely.”

The origins of the current dilemma go back to 2008 when stocks were crashing and an avalanche of investment dollars poured into the bond market looking for a safe haven. From early 2009 to now, U.S. retail investors have pumped more than $1 trillion into bond mutual funds.

Instituting exit fees would require a rule change by the Securities and Exchange Commission. The SEC has not yet announced that it is seeking public comment on this issue. But many in the financial services industry are concerned about rumors on the grapevine.

Curt Knotick, CEO of Accurate Solutions Group in Butler, said he finds it ironic that the SEC issued an investor bulletin on interest rate risk in June 2013 warning the public that when interest rates go up, prices of fixed rate bonds fall, yet the Federal Reserve is contemplating imposing an exit fee on bond funds that would limit or prohibit people from acting to preserve their investment.

“Historically, bonds and bond mutual funds have been considered safe haven by investors since they carry less market volatility risk than equities and stock funds,” Mr. Knotick said. “Yet the opposite may be true today since interest rates have been held at historical lows by the Federal Reserve for the past six years.

“Interest rates have nowhere to go but up. The big question is when? Consumers need to understand that once interest rates begin their climb, it can happen very fast, and holding bonds or bond funds could result in a loss on their investment.”

Rising interest rates could have a different impact on individual bonds versus bond mutual funds.

Investors who own individual bonds — municipal, corporate or government — can hold them to maturity and continue to receive the interest payments they are entitled to for the life of the bond. Rising rates will not affect individual bond owners unless they chose to sell the bonds before maturity for less than their original cost.

But with bond mutual funds, there is no maturity date and the market value declines when interest rates rise.

Mr. Sanford said the Fed has created a bond market bubble by instituting a zero-interest rate policy for many years, thus forcing savings and retirees to take greater risks in order to make any money at all.

“I have an issue with the way exit fees would hurt small investors, taking money out of their pocket for doing what the Fed encouraged them to do by lowering rates to zero and forcing them to step up the risk curve for more yield,” Mr. Sanford said. “Now the Fed is worried about what happens when interest rates move in the other direction.”

Tim Grant: tgrant@post-gazette.com or 412-263-1591.

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