Liquidity mismatch in open-ended funds that hold illiquid underlying assets has been focussed on property following Brexit, but a new report from ratings agency Fitch has highlighted potential challenges for Ucits bond funds.
The impact of this liquidity mismatch risk has increased to a record high in 2016, the report, Fund Liquidity Management: Progress and Pitfalls, says.
Daily dealing is currently offered by 90 per cent of Ucits funds, the report says. As a result fund managers are being urged to prepare to meet redemption requests in case of a sharp sell-off.
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.”
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 the risk of a wave of redemptions might be at an “early stage”.
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. This risk is at an early stage as managers are slowly reaching for more yield.”
Fitch also warns commercial pressures may tempt managers to raise assets close to or above capacity. It warns a liquidity shock can reveal a lack of alignment between investors’ and managers’ interests on “certain blockbuster funds”.
Furthermore some institutional investors are shifting from commingled funds to dedicated mandates on liquidity concerns, leaving some open-ended funds more exposed to redemptions from ‘momentum-driven’ retail investors.
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 heaviest outflows of £777m, followed by the £4.6bn M&G Corporate bond fund with £517m, then the £5.3bn Invesco Perpetual Corporate Bond fund, which saw outflows of £488m. 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 diversify holdings as well as retain a higher balance of cash and liquid securities. But there are trade-offs in this, such as over diversification and lower selectivity.
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.
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.”
At Investec Wealth & Investment fixed income analyst Esther Gilbert says the team monitors funds for capacity, diversification, style drift, as well as the use of derivatives and whether they are used for hedging or alpha generation.
“As a rule of thumb we would have greater concern as we moved down the credit spectrum,” Gilbert says. She notes high yield is one asset class where fund managers suggest it can be difficult to put new money to work.
“Many use index derivatives and ETFs to get invested in the short term then, when market conditions improve, they build cash bond positions over time.
“My concern would be that if they need to do this with inflows, how will they handle outflows: I’m yet to hear a convincing strategy of how funds will manage outflows and liquidity if there is a turn for the door.”
Funds are running higher cash balances than the past with high-yield funds “typically” holding around 6 per cent, Fitch says. Investment grade funds are allocating approximately 13 per cent to cash and liquid AAA/AA rated securities, the rating agency estimates.
The risk of allowing daily liquidity in funds holding illiquid assets hit home four months ago when several UK asset managers halted redemptions of 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 note 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.”
Fund managers should have a liquidity shock plan in place, Fitch warns. It recommends measures reminiscent of the post-Brexit property sector, including redemption gates, in-kind redemption, side pockets and swing pricing.
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, whilst 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 rising trading costs and friction within markets erodes performance.
Bond fund managers could go short duration, getting a little income, as well as using derivatives, Lowcock suggests.
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 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.