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Risky portfolio rebalancing threatens stability, says BoE’s Fisher

The search for growing returns in the current low-yield environment could be increasing the risks to financial stability, the Bank of England’s Paul Fisher asserts.

Fisher, the Bank’s executive director of markets and a member of the Monetary Policy Committee, told the Institutional Investor Institute in Bedfordshire yesterday that falling yields have led to widespread portfolio rebalancing – in some cases toward riskier assets.

A number of factors – such as corporates building up cash reserves and worries over the creditworthiness of some eurozone lenders – has led to a “perceived reduction” in the number of acceptable assets available to investors, he says.

Fisher points out that the US has seen a fall in issuance of investment grade bonds and Treasury Bills, while some structured and synthetic assets have lost their AAA ratings and investors remain reluctant to expose themselves to the European banking sector.

He warns the combination of portfolio rebalancing and reported shortages of high-quality assets could threaten financial stability if investors start to move toward more illiquid or complex products.

“So far, there is little evidence of excessive risk-taking on a generalised basis across the financial system,” he adds.

“But the intelligence we have gathered during 2011, notwithstanding the recent pull-back in June, has flagged a number of pockets of increasing risk appetite and a few specific markets which have been showing signs of excess.”

While this trend is most prevalent in the US, Fisher notes that it has started to spread to Europe where the high-yield corporate bond markets have seen growing levels of both demand and issuance.

“Despite the low-yield environment, market contacts have been telling us that some investors’ expectations of returns were little changed by the crisis, reflecting a combination of investor inertia and the need to earn sufficient returns to cover their liabilities,” he continues.

However, Fisher warns that “something clearly has to give” when these expectations are combined with shorter investment horizons and lower volatility tolerance – and reminds investors that seeking greater returns exposes them to higher risk.

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