Investment Grade Credit: When the flows reverse
It might seem excessively cautious to be concerned about a liquidity crunch in fixed-income markets. All the signs are that the environment will continue to be benign: monetary policy continues to be supportive, inflation remains low and most developed economies are experiencing a modest recovery.
But even though the macro-economic environment is positive, the fixed-income market has changed in recent years.
“Fixed-income market-making functions are very capital intensive businesses and banks have simply not had the excess capital to divert to this business,” says Lewis Aubrey-Johnson, head of fixed-income products at Invesco Perpetual.
Alex Thompson, principal at Mercer, agrees, and cautions against expecting a significant turnaround. “The trend of investment banks pulling back from market-making activity is set to continue as new banking regulations impose high capital charges on these activities,” he says.
“Investors were attracted to high yield because of the lower volatility of high yield compared with equity,” says Claire Ballantyne, head of bond research at Hymans Robertson. “But the flipside of lower volatility is reduced liquidity.”
The increased popularity of bond ETFs since the financial crisis has also influenced trading patterns in fixed-income markets. “Fixed- income ETFs essentially offer fund-level liquidity from what are inherently less liquid underlying securities,” says Thompson. The buying and selling of ETF products might amplify price swings in the underlying market, forcing managers to pay more attention to so-called technical factors, he adds.
“If fixed-income ETFs rebalance at the same time, then there could be a liquidity crunch,” warns Alastair Sewell, head of EMEA fund and asset manager ratings at Fitch Ratings. The problem is exacerbated when many ETFs, or large ETFs, track the same index, and is more acute in less liquid markets such as high yield.
That raises an important point: where liquidity is concerned, not all fixed-income asset classes are created equal. In markets like high yield, liquidity can and does disappear in an unpredictable manner. “Liquidity in high-yield markets is there until it’s not there – liquidity can dry up suddenly and unexpectedly,” says Sewell.
Inflows to high-yield doubled in 2013 relative to 2012, hitting almost 19 of 2013’s year-end total assets.“This raises challenges for high-yield funds,” says Sewell. “How can they adopt a strategy that allows them to maintain the returns they generate for the fund while ensuring there is sufficient liquidity if the market should become less benign?”
Fund managers have to choose between being fully invested and ensuring they can maximise return, or sacrificing some returns by keeping some of the fund in cash.
Invesco Perpetual’s fixed-income managers have chosen to take the latter route. “We have decided to improve the liquidity profile of all our funds, no matter their risk rating,” says Aubrey-Johnson. Invesco achieved this by increasing the level of cash it holds in funds, holding a higher proportion of more liquid securities and, to a limited extent, using credit default swaps. Despite this, performance of seven out of its eight income funds remains top-quartile.
“Spreads have tightened so far that we would generate relatively little extra yield by being fully invested,” Aubrey-Johnson explains. “It makes more sense to have liquidity in the fund to take advantage of any opportunities.”
However, even if a fund has built up a good proportion of liquid assets, if there is a major correction in high-yield markets, that might not be sufficient protection. Market corrections can lead to panicked buying and the illiquid nature of high-yield markets exacerbates the problem. Many hedge funds experienced a similar problem during the financial crisis.
“I’m concerned that the liquidity offered in co-mingled high-yield funds is inappropriate for the underlying asset classes, given its episodic liquidity profile,” says Chris Redmond, global head of fixed income manager research at Towers Watson.
For example, there are a growing number of UCITS high-yield funds offering daily pricing and daily dealing – requirements that might be impossible to meet in a stressed market.
“There is a very real risk that if there was a major change in investor attitude towards high-yield and they wanted to switch to another asset class, managers could struggle to deal with a high level of redemptions,” says Redmond.
If an institutional investor does choose to invest in high yield via a commingled fund, they need to take a close look at their fellow investors in that fund. “If the fund is popular with retail investors, that could be problematic, as retail investors tend to be more driven by sentiment and often act in concert, which could result in material redemptions,” says Redmond.
In addition, investors should take a closer look at funds’ liquidity terms and how managers would cope in different situations. And if the fund does have significant redemptions, would the investor be able to ride out the storm or would they be forced to sell at a loss?
Unfortunately, the idea of a close-ended fund in this space is impractical, with open-ended the accepted investment vehicle. As such, it is important that fund managers have a greater number of levers at their disposal in terms of managing fund liquidity to protect the long-term interests of investors. This would probably include not offering daily liquidity to subscribers, but something better matched with the underlying asset class, and might include gates to prevent investors from redeeming assets from the fund for a certain period of time, or to stagger outflows.
As long as high-yield bonds are viewed as a tactical investment asset class by some investors, there is scope for a material change in investor attitudes towards high yields and it could simply fall out of favour.
“For example, once interest rates start to rise and the forward-looking yield available on all bond investments begins to rise, investors may simply return to more traditional fixed-income asset classes such as investment grade and sovereign bonds,” says Redmond. “Investors need to put more effort into ensuring they really understand how the liquidity of funds is managed, including making sure they have a fund that is more closely aligned with their long-term investment objectives as well as scrutinising their fellow investors.”