What Price Yield? Fund Managers ‘Taking Excessive Risk’

Fund managers’ search for yield in fixed income is pushing them to take on additional liquidity, credit, and currency risks, according to Fitch Ratings.

A research note from the ratings agency has outlined dangers to bond fund clients posed by low yields and managers’ search for higher-paying securities.

“Managers are reluctantly looking for opportunities in lower rated, less liquid, off-benchmark bonds… despite a growing consensus that the risks are beginning to outweigh the rewards.” 

European fixed-income products—in particular high yield funds—“have benefited the most from additional central bank liquidity and improved sentiment” in the first few months of 2015, wrote Fitch analysts Manuel Arrivé and Richard Woodrow.

But managers may be tempted to overreach, they added, “potentially loosening selectivity in credit and leading to excessive risk taking.”

“As the search for yield continues unabated, portfolio managers are reluctantly looking for opportunities in lower rated, less liquid, off-benchmark bonds, adding higher credit and liquidity risk (potentially higher currency risk), often extending duration, despite a growing consensus that the risks are beginning to outweigh the rewards,” Arrivé and Woodrow wrote.

Fitch also echoed a warning sounded by some fixed-income investors that large retail funds in the asset class “could face a liquidity trap” if trying to close positions at times of market stress.

“Effective embedding of liquidity risk management in portfolio construction and a diversified, sticky investor base would mitigate potential mismatches between assets and liabilities in the event of a sell-off,” according to Arrivé and Woodrow.

So far, bond market dynamics have not led Fitch Ratings to downgrade any funds, but the agency warned that if its concerns came to pass then downgrades could follow

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