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Fitch warns on liquidity risk in European high-yield bond funds

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The European high-yield bond fund sector “appears to be operating with significant liquidity risk”, Fitch Ratings has warned.

The five largest such UCITS funds in Europe, which had €43bn of assets under management between them at the end of March, had limited holdings of highly liquid securities despite offering daily dealing, it said.

Although there was substantial variation across the funds, on average only 4% of their investments were in cash and 14% in instruments rated single-A or higher; the allocation to triple-A financial instruments was the lowest.

Fitch also noted the funds had an average duration of three to four years, depending on the extent to which they included floating-rate securities in their portfolios.

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The warning follows a number of high-profile liquidity issues in regulated funds. H2O Asset Management – a subsidiary of Natixis – experienced a high level of redemptions after it emerged that some of its bond funds were invested in illiquid holdings.

Swiss asset manager GAM is still in the process of liquidating its absolute return bond portfolios after a fund manager’s suspension led to major withdrawals from the funds.

Trading in shares of the LF Woodford Equity Income fund was suspended on 3 June after a surge in redemption requests from investors, including Kent County Council’s £6.4bn (€7bn) pension fund. While not a bond fund, the Woodford fund’s portfolio had a significant allocation to small cap, unlisted or illiquid companies.

Mark Carney

Bank of England governor Mark Carney gives evidence to the Treasury Select Committee on 26 June 2019

Last week Mark Carney, governor of the Bank of England, said funds offering daily liquidity that invest in illiquid assets were “built on a lie”.  The central bank’s deputy governor for financial stability, Sir Jon Cunliffe, referred to the high-yield bond market in his comments about mismatches between redemption periods and the liquidity of underlying assets.

Fitch said tighter regulation or severe market stress might be needed to change asset managers’ approach to fund liquidity.  They had opted “en masse” for daily liquidity, presumably on the basis of investor demand, despite this not being required under regulation. UCITS rules allow funds to offer various levels of liquidity, such as dealing as little as twice a month.

Fitch on Woodford

Neil Woodford

Neil Woodford, founder and portfolio manager, Woodford Investment Management

Fitch said the Woodford fund had “material” holdings of unlisted equities and that its gating “highlights the dangers of offering high liquidity while investing in less liquid securities, including forced asset sales, material net asset value reductions, gating and potential knock-on effects to the broader financial system”.

The UK financial markets regulator has said it would take into account the experience of the Woodford fund when finalising new rules for open-ended funds investing in illiquid assets.

On Monday Woodford Investment Management announced the equity income fund would be suspended for a further 28 days. It is working on selling assets and repositioning the fund towards a portfolio comprising larger, more liquid stocks, the majority of them for FTSE 100 and FTSE 250 companies.

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