Two bond fund managers have issued stark warnings about liquidity in fixed income markets as investor attention turns towards expected interest rate increases in the coming months.
Hermes Investment Management and TwentyFour Asset Management have both voiced concerns about the capacity of the largest bond funds in the market and the effects of reduced liquidity on their ability both to sell and to be selective in buying new securities. Both firms’ funds are significantly smaller than the biggest portfolios in the market.
Fraser Lundie, co-head of credit at Hermes, cited the high yield market as a particular concern.
“Banks’ ability to provide liquidity has reduced, and it is kept at low levels by regulation,” he said. “What is less understood is how big the market has got. The growth has been too concentrated in too few [funds]. There has been too much focus from the regulators on banks and not enough on the buy side.”
Lundie explained that smaller companies, which previously relied on banks for funding, were entering the bond market for the first time through investment banks. These organisations were in turn “exploiting forced buyers” among the large funds—particularly in areas of limited scope, such as short-duration funds—which have become reliant on new issuance to deploy cash.
“When a small company comes to market it is pre-placed with 20-30 funds, so only those 20-30 people understand the stock,” Lundie said. Banks are no longer able to taken on the high-risk debt of smaller companies—“so who will take on that risk, when no one knows about that company?” he added.
The Financial Conduct Authority in the UK issued a consumer warning in July alerting retail investors to potential risks involved in corporate bond funds relating to reduced liquidity and the effect of interest rate rises. Its predecessor, the Financial Services Authority, conducted a survey of fixed income funds in July 2012 in an attempt to assess the ability of products to cope with heavy or sustained outflows.
Speaking at an investor conference in London yesterday, Mark Holman, CEO of bond specialist TwentyFour Asset Management, said the fixed income inventories of investment banks had fallen dramatically since the crisis while some bond funds had doubled in size.
However, Holman added that “assets will get more expensive” in the short term, despite many areas of the bond market trading at record low spreads above key government bonds.
“Staying with risk is not as obvious as it used to be,” he said. “The economic cycle is still relatively young—we haven’t had the first rate hike yet. Credit is going to get more expensive before we get to a bubble.”
While the US Federal Reserve and the Bank of England are expect to announce their first interest rate increases for more than five years in the coming months, Holman played down the impact these actions would have on the market, as they were likely to be “small and gradual” hikes.
- CIO will take an in-depth look at what happens when flagship funds get too big for comfort in the September edition, published next week. To sign up for the digital edition of CIO, click here.
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