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Fixed points

Illiquidity issues remain in the secondary fixedinterest market, potentially making it difficult to sell issues if the sector’s popularity suddenly reverses. Although credit markets have come a long way since the difficulties of 2008, the situation behind the scenes is not as robust as it was pre-crisis and trading remains problematic.

According to some commentators, the situation is leading to big legacy positions in some funds, using new inflows to buy new issues and relying on duration as the main driver of outperformance.

More nimble bond portfolios are also worried about the lack of liquidity in the market should the sector’s fortunes suddenly reverse but managers of these portfolios say their smaller size does aid the situation.

Bonds have gone through a remarkable period of popularity since the credit crisis. IMA stats show that fixed-interest sectors have been the best-selling retail area of the market for six out of the eight quarters starting in the fourth quarter of 2008.

Many corporate bond funds have grown massively in size during this period of popularity. There are now 15 funds with more than £1bn in assets in this peer group, five of which are greater than £3bn in size. Just three years ago, Morningstar data shows the sector had eight funds greater than £1bn, only one of which had more than £3bn in assets.

Among the two biggest in the corporate bond peer group are the £4.5bn M&G corporate bond fund and the £6.1bn Invesco Perpetual corporate bond portfolio.

Just because liquidity continues to be tight does not mean these big funds cannot liquidate their positions in the event of redemptions.

Risk and liquidity management has become a central issue for most fund managers since 2008. However, there is the inference that a small bond deal may go through more quickly and at a better price than a bigger one.

The effect of this would be for bigger managers to hold legacy positions, not trading their back book of business and using new inflows to asset allocate instead.

In such a scenario, Alliance fixedincome manager Gareth Quantrill says duration becomes a bigger driver of outperformance than stock selection.

He says: “In a universe of around 1,000, when you have hundreds of positions, you are so close to the market that you would be unlikely to outperform on stock selection alone.”

With greater asset sizes, the portfolios at M&G and Invesco Perpetual have certainly broadened out. The Invesco Perpetual corporate bond fund has more than 430 holdings while the number of issuers alone – not holdings – in Richard Woolnough’s M&G corporate bond portfolio is over 300.

Still, performance in the two portfolios has remained robust despite their growing size. Over three years to November 11, the Invesco fund is ranked eighth in the peer group on an offer to bid basis while M&G corporate bond has returned more than 25 per cent and is ranked second. Over one year, there is a slight change. M&G corporate is 26th while the Invesco fund drops to 39th out of 92.

Whether the performance generated by these portfolios is solely or predominantly from duration calls, stock selection or asset allocation is difficult to tell. And whether they would struggle to trade if they needed to is also difficult to ascertain. Neither M&G nor Invesco Perpetual want to comment.

Of the current liquidity situation in the market, John Stopford, co-head of fixed income at Investec and manager of its £240m strategic bond fund, says: “We are finding it better than others might because we are medium-sized rather than enormous. Even big investors would struggle in today’s climate as it could take them a while to get out of some positions.”

Quantrill echoes a similar sentiment. He notes that those traders there are in the market, and there are fewer today than pre-crisis, are hampered by new regulations, making them less willing to deal in volume.

He says: “If you are a big fund, in the past, at the outside, you could get out of something in a week, now it could take six months.”

In addition, while in the past trading in volume could result in a better price, due to today’s economies of scale, it means the opposite. Quantrill says traders are afraid of big volumes. For instance, he says market quotes used to be given for big bulk business whereas today quotes tend to revolve around smaller-sized deals.

So what is the optimal portfolio size for a bond fund? This is a diffi-cult question to answer, according to Stopford, who says managers depend on the level of turnover they need or want and what proportion of the fund they want to be able to trade daily, weekly or monthly.

“Two to four times the size of our portfolio would be fine but at 20-40 times that size, you are more a hostage to fortune,” he says.

As long as the environment remains good for credit and appetite is there, there should not be a noticeable impact on funds when there are pockets of difficult dealing times, such as the UK experienced in May.

Stopford says right now trading in most investment-grade issues is okay and while high yield may require a little more work, liquidity is still reasonably good. He says the problem will be if or when bond popularity changes and everyone is trying to get to the exit at the same time.

The changing dynamics of bonds and what it may mean for portfolios is an aspect of fixed-interest investing that advisers had better get accustomed to as it is unlikely to go away any time soon, if at all. Stopford says he doubts that we will ever see a return to a pre-crisis liquidity levels again while Quantrill says spreads on issues remain wider than they once were and the industry is having to get used to a “new market size”.

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