Bond firms face a liquidity crunch as fund managers are being urged to prepare to meet redemption requests if there is a sharp sell-off.
A recent report form ratings agency Fitch warned of a mismatch within open-ended bond funds offering daily liquidity while holding less liquid securities. The report says the likelihood and impact of this liquidity mismatch risk has increased to a record high in 2016.
Fitch analyst Manuel Arrive says: “Drawdowns resulting from fire sales in illiquid markets increasingly put fund capital at risk, as bond carry returns have become insufficient to offset volatility.”
For the managers of funds most vulnerable to redemption requests in case of a sharp sell-off in the market, analysts have warned there are challenges ahead.
Psigma Investment Management head of investment strategy Rory McPherson says the lack of liquidity in the bond market is not an “immediate risk” for bondholders, but argues risks of a wave of redemptions might be in its “early stages”.
He says: “This is definitely something to start thinking about as bond managers ‘reach for yield’ and buy into less traditional forms of fixed income given the low yields on offer in traditional areas such as sovereign bonds and investment grade credit.
“If there is a quick wave of redemptions, bond managers will be forced to sell the most liquid bonds leaving the funds with a higher concentration in illiquid names. I think this risk is early stage as managers are slowly reaching for more yield.”
The risk of allowing daily liquidity in funds holding illiquid assets hit home four months ago when several UK asset managers gated their commercial property funds in the wake of the EU referendum as many investors tried to exit the asset class.
Aberdeen Asset Management head of pan-European fixed income Wolfgang Kuhn says he doesn’t rule out such a scenario happening with bond funds too. He does not several differences between bond and property sell-offs however.
He says: “Market participants are aware that central banks will do all it takes to keep things right. It is difficult for market participants to run away in panic. You’ll have more volatility but not difficulty of buying or selling.”
Managers will sell the most liquid bonds, leaving the funds with a higher concentration in illiquid names
Architas investment director Adrian Lowcock says while fund managers are very conscious of market liquidity and have put in place measures to protect capital, he believes only a significant economic shock event could trigger a sharp bond sell-off.
He says: “Because of quantitative easing, the alternative is buying higher risk assets with a lower yield. Because the liquidity issue is in quality bonds it means you would have to have a big interest rate rise shock for investors to consider selling, but even then people are likely to remain in these defensive assets. That is why, while liquidity is a risk, it would need a major change to interest rate expectations or global growth outlook for that risk to become a reality.”
However, Lombard Odier Investment Managers chief investment strategist Salman Ahmed expects increasing pressure on higher volume active management as increased trading costs and friction within markets erodes performance.
Sizing up the problem
Of the top 20 open-ended bond funds domiciled in the UK ranked by size, eight had combined outflows of more than £2.7bn in the 2015/16 financial year, according to Morningstar estimates.
The £4.1bn M&G Strategic Corporate Bond fund saw the largest losses of £777m, followed by the the £4.6bn M&G Corporate bond fund with £517m, then the £5.3bn Invesco Perpetual Corporate Bond fund, which saw outflows of £488m and outflows. More worryingly, in September alone, the same funds lost £143m, £222m and £86m respectively. (See table below)
As the Fitch report suggests, portfolio managers have been adapting their investing strategies to diminish the threat of liquidity risk in their portfolios.
Some managers take smaller positions and over-diversify holdings as well as retain a higher balance of cash and liquid securities.
Fidelity International fixed income investment director Curtis Evans says while the trend of less liquidity in the market is likely to continue, he holds a buffer of liquid assets to manage daily flows. He also has an oversight committee in place to monitor liquidity across all the funds.
While liquidity is a risk, it would need a major change to interest rate expectations or global growth outlook for that risk to become a reality
Evans says: “It’s important to remember that in credit investors are getting paid a premium over government bonds in recognition of both the credit risk and illiquidity risk. While short-term investors will need to be careful in this environment, we would encourage long-term investors to keep diversification at the heart of any tactical positioning.”
Lowcock also suggests bond fund managers could go short duration, getting a little income, as well as using derivatives.
However, Legal & General Investment Management head of credit strategy Ben Bennett retains a bias to long duration bonds given the backdrop of weak growth and low inflation, but the team is tactically positioning for yields to rise in the near term.
He says: “We still see adequate liquidity in order to be able to trade our funds as necessary to manage our portfolios.
“However, we remain concerned that financial repression is squeezing liquidity; this is another reason our portfolios are conservatively positioned with respect to credit risk.”
Meanwhile, Ahmed recommends investors to trade-less and build safer portfolios that exhibit quality and consider fundamentals-driven portfolio construction approaches within a low turnover framework that focus on credit default mitigation.
McPherson says bond funds could also invest in loans and asset-backed securities, which are less liquid. He accesses these through Twenty Four Asset Management’s Asset Backed Income and Focus funds.
He says: “These funds have excellent numbers year-to-date but were heavily sold off in the early part of the year due to these markets closing up.