This could well be the case in credit markets now, according to Hermes’ Fraser Lundie, who warns the FCA's obsession with the banks since the financial crisis has meant it has failed to notice the threat posed by the ballooning size of bond funds.“The regulator has been too focused on banks and not nearly focused enough on me – on the buy side – and that has allowed funds to become too big for the market,” Lundie (pictured) said.
Lundie, co-head of credit at Hermes, says banks are now taking advantage of large funds’ need for liquidity, making them forced buyers of increasingly risky bonds, but without the appropriate reward.
“Any mandate that is too constrained [in terms of geography or type of debt] or too big in terms of size is not fit for purpose in my opinion. You need flexibility to be a successful credit portfolio in a post-crisis environment,” he said.
“So many mandates were written in a pre-crisis world and in my opinion are just not fit for purpose, either because they lack flexibility or because they’re now too big.”
“People need to be more realistic about fund capacity. Is it still appropriate to be an active credit manager with tens of billions? I don’t understand how that works.”
While Lundie thinks fund size should be a “moving target”, because what may be too big one year may be fine the next, he thinks funds larger than $1.5bn start losing the capability to deal with the dangers in the current environment.
“I think $1.5bn is a sensible place to cut. That would put us in the bottom of our peers in the Strategic Bond sector,” he said.
A number of funds in the IMA Sterling Strategic Bond sector are running at much higher levels, most notably Richard Woolnough's £22.3bn M&G Optimal Income fund.
IBOSS’s Chris Metcalfe echoed Lundie’s fears in a recent FE Trustnet article and he is putting his money where his mouth is. The investment director dropped the highly rated Jupiter Strategic Bond and Fidelity Strategic Bond funds from the firm’s recommended list, citing size concerns.
However, recent FE Trustnet research counters Lundie and Metcalfe’s worries. Data from FE Analytics suggests fund size has had little impact on bond fund returns in the past.
Still, many experts are warning that the liquidity crisis this time around will be far worse than in previous cycles.
Lundie says people simply don’t understand how big the market has become. With fewer banks willing to lend to businesses, more and more are coming to the debt market to get funding – creating a wealth of new issuance, but with little research to understand the risks related to these unknown entities.
The manager also says that investors aren’t getting paid for the risks they are taking in high yield. He points out that the attraction of the asset class in the past was that it could deliver capital growth and income, but with less risk than equities.
Now that spreads have come in so much, he warns this has eroded high yield’s ability to provide capital appreciation. This means investors are paying over the odds for bonds that can only fall in value.
“CCC risk in high yield is right next door to equity,” he said. “People are buying CCC bonds that can’t go up and you would never do that with equities. You will never buy an equity that couldn’t go up.”
“In my mind, high yield returning 6 per cent last year was a [significant underperformance]. The S&P did 30 per cent last year.”
Lundie says there are four things investors can do to mitigate the risks in the credit market.
- Open up your universe – be global because it stops dependence on the primary market
- Invest across the capital structure
- Invest across debt instruments – utilise other forms of debt such as loans and CDSs (credit default swaps)
- Open up all parts of the credit curve
The manager says the fund takes a high conviction approach, holding between 50 and 75 names at all times. It targets annual returns of 7 per cent over the long term.
“It’s a go-anywhere portfolio within liquid credit markets,” he said.
The fund has returned 1.69 per cent in its short history, compared with 1.75 per cent from the IMA Sterling Strategic Bond sector over the period.
Performance of fund and sector since launch
Source: FE Analytics
Lundie also runs the Hermes Global High Yield Bond fund, which has outperformed both the IMA Global Bond sector and the Bank of America Merrill Lynch High Yield Constrained Index since launch in November 2012.
The fund is up 19.61 per cent over this period, compared with just 3.5 per cent from its sector.
Performance of fund, sector and index since 2012
Source: FE Analytics
The fund has ongoing charges of 0.8 per cent.
