Will there be a liquidity crisis in corporate bonds?
The liquidity of corporate bond funds has been subject to recent FSA scrutiny, but is a liquidity crisis a possibility and how can bond managers protect their funds?
The regulator recently sent a letter to corporate bond fund managers asking them what risk controls and monitoring they have in place to manage large scale redemptions in the face of low market liquidity in the corporate bond sector.
Both funds are IFA favourites in the corporate bond sector. The corporate bond fund has had more than £1bn of inflows since June 2011, while the strategic corporate bond fund has had inflows of £1.3bn, according to figures from FE Analytics.
Woolnough (pictured above) says the rapid growth of the funds has made it more difficult to implement his investment views, but he has “coped” with the inflows.
He says: “We think all the time about fund size at M&G. With respect to the investment-grade bond funds, we think it is in the interests of existing holders of the fund to explore options to slow the inflow of new money that comes into the fund to control the growth of the fund.”
Both funds remain open to investors while the group explores ways to stem inflows.
The popularity of the corporate bond sector has spiked in the current environment where investors are desperately searching for yield. The corporate bonds sector had the highest net retail sales of all the IMA sectors in four out of the first five months of this year.
Corporate bonds atttracted £481m in total net retail sales in May.
OPM Fund Management chief investment officer Tony Yousefian says he has considered corporate bond liquidity to be an issue for a while.
He says: “We have been concerned about corporate bond liquidity for quite some time and the difficulty large funds may encounter if there are large scale redemptions. The longer the flight to the fixed interest market continues, the worse the correction in corporate bond prices will be when a liquidity crisis happens.”
Yousefian says he can see a scenario where gilt yields rise and investors move out of fixed interest into other asset classes.
He says: “Once gilt yields have begun to pick up, that is where you start to see investors move out of fixed interest, like corporate bonds. That could be a trigger for a liquidity problem.”
Consequently, Yousefian stays clear of the larger bond funds. In the £36m EFA OPM Fixed Interest fund, he prefers to hold smaller funds such as the £53m JPM Sterling Corporate Bond fund and £152m BlackRock Corporate Bond fund.
Ignis Asset Management head of credit Chris Bowie (pictured) says he agrees there is illiquidity in the bond market.
He says: “Illiquidity in the bond market has accelerated since the financial crisis. The bond market is an over-the-counter market and you buy corporate bonds from investment banks.
“Investment banks are only prepared to sell them if they own them themselves and they only own them if they use their own capital to buy them. The capital banks have has massively shrunk so investment banks have little to offer in terms of purchases.”
He adds that credit derivatives can be used in a corporate bond fund to increase liquidity.
Bowie says a bond position can be eradicated by balancing a long position with a short position taken through a credit default swap. This is helpful if the long position on a bond cannot be sold.
Bowie has doubled the turnover in credit default swaps in his £265m Ignis Corporate Bond fund this year compared to last year.
He says: “I expect to continue using more of these derivatives. Prospects for liquidity are not good while investment banks are not willing to take risk trading corporate bonds. The regulator is still asking them to continue to improve their capital ratios.”
Bowie says one way to improve liquidity in the bond market is to trade corporate bonds on an exchange.
He says: “You would be matching buyers and sellers in the market. Instead of just individual conversations, trades are visible to everybody on an exchange.”
Axa fund manager Nick Hayes, who runs the £167m AXA Sterling Corporate Bond fund, says liquidity in bond markets has always been an issue.
He says: “The problem of low liquidity was exacerbated in 2008 and 2009 and it is an issue we think about in portfolio construction.”
Hayes says liquid assets such as gilts and cash can be used to provide increased liquidity during periods of risk aversion.
He has doubled the gilt exposure in the Sterling Corporate Bond fund from 2 to 4 per cent and added a 4 per cent position in cash in May.
Hayes says: “Buying liquid assets is a tool we use to provide liquidity in the fund. Also, returns on cash are known and government bonds perform quite well during such periods of market stress.”
Investment Quorum chief investment officer Peter Lowman says his firm prefers bond exposure through strategic bond funds, as they are less risky because they can invest across the bond spectrum.
He says: “While the possible issues of UK corporate bond liquidity is worrying, the benefits from global diversification is key. Using strategic bonds gives you both diversification and better liquidity.”
Brooks Macdonald head of investment strategy Gemma Godfrey says investors can reduce the risk of their exposure to corporate bond funds by capping exposure to each fund to avoid holding too large a position and monitoring corporate bond funds’ cash positions on a monthly basis.
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