Minsky and bond mutual funds - illiquidity feedback loop

Since the Financial Crisis, there has been significant discussion about Hyman Minsky and Minsky moments. The Minsky moment would be a sudden market collapse caused by a long period of prosperity or low volatility that led to increased speculative behavior. When there is a long period of market calm and prosperity, there is a greater willingness to borrow and take on speculative investments. If there is a reach for yield in calm periods, an overreach will lead to the potential for a market collapse. Unfortunately, the  next market collapse may not come in the same way as the last. While regulators have worked to reduce bank leverage, the next collapse will likely come from somewhere else. 

The next crisis may come from the lack of liquidity in bond mutual funds who have reached for yield. The WSJ has done a nice piece of research on the lack of liquidity in some bonds funds. These are the big funds, so the problem is real. The eight largest funds represent close to $200 billion in assets and each have more than 20 percent in illiquid assets. These  funds are not borrowing money, but with daily liquidity, there is the potential for a run on the fund. If there are large outflows from mutual funds and the illiquid assets cannot be sold, then these risky assets will become a greater portion of the assets and increase fund risk. This could lead to more fund selling and a further increase in illiquid assets as a percentage of the fund, or there is forced selling of illiquid assets which leads to poorer pricing. In either case, there is a negative feedback loop that cannot be easily stopped. This will qualify as a Minsky Moment. 

We think a closer look at bond mutual funds and bond ETF's is warranted as potential place for the next crisis especially if we have a rising rate market.