Very low levels of liquidity, crowded positioning and small trading ranges all pose very large threats to giant bond funds, according to star manager Dickie Hodges, who says these issues have worsened over the past year or so.
Hodges was one of the leading lights in the IA Sterling Strategic Bond sector during his tenure on the L&G Dynamic Bond fund but left the group in May last year to set up his new Global Dynamic Bond offering at Nomura.
Performance of fund versus sector under Hodges
Source: FE Analytics
During his time at L&G he was one of the more vocal managers about the threat posed by multi-billion bond funds given the falling levels of liquidity within the corporate credit market thanks to sheer amount of money now in the asset class and the tighter regulations placed upon investment banks. 
The major concern surrounding giant bond funds, which is yet to come about, is that if yields were to spike and investors started redeeming their units at the same time, the managers will be unable to offload their assets in a hurry and therefore incur hefty losses.
During his final few months at L&G, Hodges’ fund’s AUM reached £2.25bn and his new Nomura portfolio weighs in at a far more nimble £70m. He says he is thankful for that, given that liquidity has worsened considerably during his short period away from running funds.
“It is easier to manage a smaller amount of money in this environment. There was no difference running a £2.25bn fund back in April 2014, but things have materially changed,” Hodges (pictured) said.
“Liquidity has materially changed. The secondary market liquidity has materially changed. [For] investment banks, through increased regulation, the cost of warehousing and holding securities has materially changed and you can see this in the bid/offer spread on bonds, which is significantly greater than it has been in the past.”
He added: “From the point of view of managing a smaller fund, it is easier than managing a bigger one because of the liquidity that is available.”
Investors will have no doubt read about the falling levels of liquidity in the corporate bond market. In a research note last year, RBS showed that liquidity in credit markets, which it categorised as a “combination of market depth, trading volumes and transaction costs”, had declined by close to 70 per cent since the financial crisis.
Hodges also points to recent research conducted by Citigroup, which highlighted that out of a universe of 26,000 publically registered bonds, just 227 of those are traded daily.
Of course, these concerns have been around for a number of years now.
However, Hodges says there have been a number of warning shots over the past few months which suggest the problems surrounding a lack of liquidity have become larger as there is a growing herd mentality within the asset class.
“Greece caused a complete withdrawal of liquidity from debt capital markets, no investment bank wanted to buy a bond at all. Then we had China coming through and the equity market performance we’ve seen more recently and exactly the same thing happened, liquidity completely dried up.”
“Everyone is positioned in exactly the same way. All money managers are long risk so we all hold the same securities.”
One major cause of a bond sell-off, according to most giant fund critics, would be a rise in interest rates in the US or UK.
They say that the situation could be similar to what happened in 1994 when Alan Greespan’s US Federal Reserve (Fed) raised rates – albeit worse this time around given yields are far lower than they were 20 years ago.
Performance of bonds in 1994
Source: FE Analytics
However, given the deflationary forces emanating out of China, slow economic growth and low commodity prices, Hodges sees no reason for the likes of the Fed to tighten policy further.
“I’m absolutely certain people’s Armageddon scenarios around fixed income will happen at some point, but it’s not going to be this year and I question whether it will be next year,” Hodges said.
Nevertheless, he admits that bonds are very expensive and also warns that there have been a number of nasty developments within the market over recent months.
He points out that government bonds have been in a trading range which makes it very difficult for bond fund managers to make money. Given the amount of trading that has gone on, he says transaction costs have increased and managers have had to take bigger bets to try and outperform.
This has meant, according to Hodges, that most managers have ended up owning very similar assets.
“An awful lot of what has happened reminds me of 2007. That doesn’t mean we are about to have a 2008, but a lot of what has gone on is like in 2007,” Hodges said.
Performance of sectors between 2007 and 2008
Source: FE Analytics
“We are all doing the same thing and because we all want to be differentiated and want to make a higher return than anybody else, we are trying to call turning points and then we all put on a bigger bet. But that can only end in one way, I’m afraid, and that is for everyone to be disappointed.”
He says this all comes back to the dangers facing giant bond funds.
“The big difference between now and 2008 today, which is going to be the biggest problem, is that there was no regulation of banks. They had huge balance sheets and were providing significant levels of liquidity to the secondary market.”
“The big difference now is, when markets fall, you cannot sell in any sort of size. That’s the thing that worries me considerably. It’s a big, big problem for the large funds.”
Certain giant bond funds have struggled during this year’s difficult market. One of the best examples, according to FE Analytics, has been FE Alpha Manager Richard Woolnough’s £19bn M&G Optimal Income fund.
It currently sits in the IA Sterling Strategic Bond sector’s bottom decile with losses of 1.46 per cent and has seen outflows of £3bn over the past three months. FE analyst Thomas McMahon says that underperformance hasn’t necessarily been due to size or redemptions, however.
“One reason for his underperformance is that he has been underweight duration rather than the size of the fund,” McMahon said.
“He has been bullish on the economy and expecting and preparing for a rate rise for some time and the fund underperformed because of the good performance of duration in the first part of the year.”
It is unknown whether it has been due to size or positioning, but an equally weighted portfolio of the five largest strategic bond funds (Invesco Perpetual Monthly Income Plus, Jupiter Strategic Bond, M&G Optimal Income, PIMCO Income and PIMCO Diversified Income) has underperformed against the peer group average, and has done so with higher drawdowns, since government bond yields started to spike in April.
Performance of largest bond funds versus sector since April
Source: FE Analytics
There are a number of other leading industry experts, such as Kames’ Stephen Snowden, who hold a similar view to Hodges.
“Common sense would tell you that the bigger anything gets, the harder it is to change. If this industry is about trying to pick the right funds for the future, looking forward, I think those that are more nimble have a much better chance of delivering the returns over the next five years,” Snowden said last year.
Of course, though, there are those who believe the giant bond argument doesn’t stack up.
One who holds that view is star manager Paul Causer, who runs the £5.5bn Invesco Perpetual Corporate Bond fund. He told FE Trustnet in September 2013 than these concerns had been blown out of all proportion.
“In my opinion, if everyone wants to take money out of the asset class, then everyone would be hit. If you’re trying to sell £20m or £2m you are going to the same market makers. It’s the price you get for the bond which is the issue, not whether you’re going to be able to sell it,” Causer said.
On top of that, a previous FE Trustnet study showed that, up to that point, fund size seemed to have had no impact on performance over the longer term or during periods of poor liquidity.
However, given the deteriorating levels of liquidity, crowded positioning and low yields on offer, Hodges says it is naïve to think that multi-billion funds would be able to dodge a sharp liquidity driven sell-off.
“There is no way. On Monday when equity markets were collapsing it was easier for me to sell £250,000 worth of bonds but if a large bond fund manager needed to sell £2.5m on that day there is no way anybody, any bank would buy. If they did manage to, they would be selling at a very distressed price which would cost investors.”
He added: “It’s impossible. This market is broken and it’s a joke.”
In an article next week, FE Trustnet will take a closer look at Hodges’ new Nomura Global Dynamic Bond fund and see how he is positioning his portfolio in the current environment.
