Are bonds facing a liquidity crisis?


The hunt for yield has left many investors and fund managers ramping up their risk levels in a bid to deliver returns. With bonds in particular delivering historically low yields, managers have been forced to go down the credit spectrum to meet return targets.

There is the prospect of an interest rate rise on the cards, which could have a major impact on markets. Bank of England governor Mark Carney has laid out his plans for a rate rise, hinting that the time may come at the end of this year or the start of next year.

Coming with such changes in markets is an expected ‘great rotation’ out of bonds, as any rise in interest rates makes yields even more unappealing. While this has been predicted for some time, there are some signs that this movement out of bonds may be starting.

July saw the first outflows from bond funds, losing $600m (£383m) in the month alone, according to Lipper.

In June, the fixed income sector saw £198m of outflows for the month, according to Investment Association data. Hit particularly hard were Strategic Bond funds, which saw £104m of outflows for the month, while the Global Bond sector saw £101m of outflows and the Global Emerging Market Debt sector saw £69m of outflows.

With the hint of future outflows on the horizon, talk has turned to liquidity in bond funds, and just how quickly investors can head for the exit.

“A period of rising rates is a catalyst for negative returns. Then negative fund performance causes outflows and it becomes a little bit of a mismatch of liquidity in assets in the funds and the daily liquidity they promise. You effectively get a fire sale situation and you potentially got funds sold at depressed prices,” says Andreas Michalitsianos, manager of the JP Morgan Asset Management Sterling Corporate Bond fund.

Research from Lipper looked at whether bond fund managers have ramped up their investments in riskier debt.

The data shows that holdings in BBB-rated credit have risen significantly over the past five years. Currently, on average, bond fund managers have 38.4 per cent allocated to BBB-rated credit, the Lipper data shows. This compares to 17.4 per cent five years ago.

However, surprisingly, the average bond fund has not ramped up investments in non-investment grade debt, says Jake Moeller, head of UK and Ireland research at Lipper. But scrutiny of managers is essential, he says.

“While this might provide investors some comfort, it should be noted that there is considerable variation of credit exposures among individual fund managers,” he says. It is important for investors to keep an eye on the most recent factsheet to see where a fund manager is exposed.”


“Furthermore, an aggregate increase in debtor quality will be of only limited assistance to investors in the event we see a mass rotation out of high-yield bond funds,” Moeller adds.

Larger funds, in particular, require close monitoring, says Moeller. He highlights the M&G Optimal Income fund, which has soared to £19.8bn in assets, as at the end of July.

“M&G are the best bond fund managers but that fund has got too big. How many securities are in the portfolio?” asks Moeller.

Drilling down into the corporate bond sector, analysis of bond funds shows just how concentrated investors are in the largest funds, and in turn how concentrated those managers are in the largest issuers.

Of the £24bn in assets under management in the sterling corporate bond space, much of it is sitting with a small number of large funds, including the £4.6bn M&G Strategic Corporate Bond, the £5.6bn Invesco Perpetual Corporate Bond Fund and the £3.3bn Fidelity Moneybuilder Income fund.

Looking at the holdings of those funds, Tesco corporate bonds account for £350m in holdings among the largest five sterling corporate bond funds, while those same five funds account for nearly a quarter of Old Mutual issuance, and nearly 20 per cent of outstanding Tate & Lyle issuance.

One manager who is avoiding some of the large issuers, such as Tesco, is Michalitsianos.

“Our first line of defence is to be comfortable with the credit quality of that issuer. If I look ahead and there are enough headwinds is it advisable to build up a significant position in that issuer?” he says.

The concentration of investor assets in the largest funds has been compounded by multi-manager, discretionary fund managers and advisers herding into funds too.

“Put simply, we all own the same funds,” says Alan Durrant, chief executive of Wellian Investment Solutions and Harwood Multi Manager.

“There may be favourites in other sectors but in fixed income it is particularly pronounced. If a few key multi-managers, networks and stockbrokers turn against a fund its assets could implode very quickly.”

The processes of the market will make any mass sell-off more painful, argues Durrant, as the bond market lacks the screen-based pricing found in equities. “If there are no buyers, there is no price,” he adds.

As was seen in the previous crisis, this can lead to assets previously priced at 100 heading south to 90, 80 or 70. The push for liquidity to meet redemptions also results in bond fund managers selling their favourite, better performing bonds just to meet outflows.

“It doesn’t take a lot to move markets these days,” says Michalitsianos.

“Clients may not suffer a hard close of the fund but their wealth will certainly suffer in such a fund,” adds Durrant.

There is no easy route to weeding out the more liquid funds, better able to withstand a redemptions run.

“Setting a rule that we won’t invest in a fund above £Xm is too blunt a tool. A £5bn fund invested in a wide spread of quality sovereign bonds might be much more liquid than a £1bn fund in high yield,” says Durrant.

Instead, fund selectors need to look at where the assets are coming from – sticky institutional cash or more flighty retail money, and how diversified the fund is across issuers, sectors and duration, among other factors.

While an interest rate rise in the UK may still be far off, meaning any bond fund exodus is also not just around the corner, investors need to prepare, warn experts.

“An interest rate will come and when it does there will be blood on the streets,” says Moeller.