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Hermes: The areas most exposed to a liquidity crisis in bonds

20 August 2014

Hermes’ Mitch Reznick says the time has come to protect yourself from a “sustained” sell-off in fixed income – particularly high yield.

By Alex Paget,

Senior Reporter, FE Trustnet

Investors should make sure they are not overexposed to lowly-rated credit in their portfolios, according to Hermes’ Mitch Reznick, who says that large parts of the high yield bond market are now very susceptible to a liquidity driven crisis in fixed income.

ALT_TAG Reznick is co-head of credit at Hermes along with Fraser Lundie, who recently told FE Trustnet that bond markets have never been as “consensual”, with high yield and low duration dominating investors’ portfolios.

With liquidity worsening in recent months, Reznick says investors now need to avoid these “crowded trades”, and take shelter in higher quality bonds. He has been doing exactly that in his Hermes Multi Strategy Credit fund, which he thinks is adequately protected from a possible crisis.

“Relative to the index, although it isn’t an index fund, it has a higher credit quality,” Reznick (pictured) said.

“We think that you are not necessarily paid for the credit risk you are taking in CCC or poor single-B rated bonds, not because there is systemic default risk, but because when there is a sell-off those are the names that really underperform and that again will be magnified in an environment of very thin liquidity.”

“To some degree, we are not in a ‘buy and hold market’, but a ‘buy and almost incapable of selling market’ instead.”

Some managers with a natural bias towards quality bonds such as Fidelity Moneybuilder Income’s Ian Spreadbury have a similar view to Reznick, though many managers continue to have a high weighting to high yield.

Funds in the IMA Sterling High Yield sector are clearly at risk if Reznick’s concerns are realised, though a number of Sterling Strategic Bond funds are also heavily exposure to debt with a sub-BB rating.

Royal London Sterling Extra Yield
– one of the best performing portfolios in the sector of recent years – has 38 per cent in debt rated BB or lower, and a further 40 per cent in unrated bonds.

High yield bonds have been some of major beneficiaries of the recent bull-market.

According to FE Analytics, the Barclays Global High Yield index has returned 79.53 per cent over five years.

As a point of comparison, the MSCI AC World equity index has returned 77.56 per cent over that time.

Performance of indices over 5yrs

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Source: FE Analytics



However, Reznick says investors shouldn’t expect those sorts of returns to be repeated as the outlook for fixed income is so uncertain.

The manager’s primary concern is the illiquidity in the market, meaning that investors’ ability to trade quickly and efficiently has been hindered.

He says those conditions are likely to worsen in the event of a sell-off.

According to data from RBS, liquidity in global credit markets, which they define as a combination of market depth, trading volumes and transaction costs, has declined by around 70 per cent since the financial crisis, and is still falling.

“Trading liquidity is evaporating out of bond markets,” Alberto Gallo, head of European macro credit research at RBS, said.

“The recovery in credit has been about low rates pushing capital into risky assets and helping firms to refinance. This has made bond markets “the new banks”, providing most credit to the economy. But it has also pushed to take higher risks.”

“What happens if low-for-long policy reverts and investors head for the exit? We fear that systemic risk is being left unchecked in financial markets.”

A number of managers have recently warned about the outlook for high yield bonds, stating that their currently high valuations, which have made them more susceptible to movements in interest rates, could result in a vicious sell-off.

High yield bonds have already had a turbulent time over the summer months with money pouring out of the asset class as a result of poor liquidity, concerns over an early rate rise in the US and growing geo-political risk.

Performance of sector vs index over 3 months

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Source: FE Analytics


However, as the graph above shows, the asset class has rebounded recently.

Nevertheless, Reznick says that there is still a high likelihood of a much greater correction in the future.

A significant sell-off is most likely to happen if large investment banks start to panic and try to dump their high yield assets in one go.

The causes of such an event still remain unclear, but Reznick says he isn’t going to wait around and find out.

“It’s really in that second wave that things really get concerning,” he said.

“This summer was more of an opportunity to add to areas that we had been avoiding, such as higher quality names which had been trading close to their call price.”

“[For a liquidity-driven sell-off to occur], we would need to see more sustained selling because balance sheets in the market can absorb the first kind of shock.”

“If it is more sustained and perpetual, then investors and managers will have to go beyond selling their most liquid names and try sell some of their smallest names. That’s when bond prices can really start to move.”


Reznick and Lundie launched their £170m Hermes Multi Strategy Credit fund in May this year.

The managers have a global, go-anywhere approach and Reznick says that bond managers will need that sort of flexibility to navigate through what will likely be a difficult few years for credit.

According to FE Analytics, the fund – which sits in the FCA offshore recognised universe – has returned 1.37 per cent since its launch.

The fund initially rallied, but has fallen over recent months.

Performance of fund since May 2014


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Source: FE Analytics


Reznick and Lundie have avoided “crowded trades” such as the raft of new issuances in Europe, but have been adding exposure to areas of emerging market debt on the back of attractive valuations.

The fund currently has a yield of 3.81 per cent and it pays dividends out twice a year.

The ongoing charges figure (OCF) is 0.81 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.