Many of the large open-ended corporate bond funds could be at risk of being stuck with less liquid, higher risk bonds during another sell-off, says Vermeer Partners head of fund research and investment director William Buckhurst.
After watching the recent gating of many open-ended property funds because of liquidity mis-matches, Buckhurst drew attention to liquidity risks of large open-ended corporate bond funds – highlighting those over £1bn in size.
He added that the ever-growing size of wealth management firms and other fund buyers has seen heavy inflows into the larger bond portfolios rather than smaller strategies, as investors attempt to avoid being one of the biggest unitholders and the problems associated with that.
“All of this money is having to find its way into a relatively small number of funds,” he said. “Given the size of these funds, they often have to go further down the credit scale just to get all of the money invested”.
Due to the fact that corporate bonds tend to be traded over-the-counter or off-exchange, they are generally less liquid than equities and Buckhurst believes large corporate bond funds are not compensating investors for the additional liquidity risk they face in the event of mass redemptions.
There are 99 corporate bond funds in the IA Sterling Corporate Bond sector, which is the third largest in the Investment Association universe in terms of assets under management. Of those, 25 are over £1bn in size but they run around 77 per cent of the money in the popular peer group.
IA Sterling Corporate Bond sector and its 10 largest members
Source: FE Analytics
Buckhurst said that while the bond funds that stick to higher-grade credit are less affected by liquidity concerns, “if you want to invest into lower grade high yield bonds, anything bigger than £1bn is too much”.
He conceded that a serious Armageddon-type liquidity crunch scenario is only a minority possibility, but added: “If you have to invest in fixed income markets, which most investors do, why take the additional risk in investing in a very large fund where clearly the odds of a liquidity crisis are higher?”.
He said that disaster in the bond market could be averted if central banks inject liquidity into the system, which is exactly what the US Federal Reserve is doing by buying up investment grade corporate bonds.
“Don’t fight the Fed” also applies to corporate bond investors, according to Buckhurst, but he warned that “corporate bonds tend to be less liquid than equities”.
Not many investors seem to be paying attention to liquidity risk because so much money still flows into the big bond funds, according to Buckhurst.
“At first glance people tend to think the bond funds can be lower risk and safer, that’s why they don’t need to do the due diligence they might do on an equity fund. I’d almost argue the opposite,” he said.
A metric Buckhurst uses to assess the risk to liquidity of bond funds is fund flows. How quickly a portfolio could be liquidated under normal circumstances is a “blunt tool”, he argued, because fund managers usually don’t liquidate large portions of the funds under “normal circumstances”.
“We saw this in 2008: what felt like a conservative bond fund with 20-25 per cent in high yield, a month later that fund had 50-60 per cent high yield. They would say: ‘We had to sell all our investment grade stuff, it was the only stuff that was liquid’,” he explained.
“The only stuff left was downgraded to junk. Then before you know it, you have a 70 per cent junk bond fund. Then people panic and want to sell the fund, then it becomes a self-perpetuating cycle.”
Buckhurst said that while most active bond managers will move out of distressed credit situations before they become distressed, “you can only be swift and nimble and move out of distressed areas if your fund is small enough that you are able to sell your position”.
Bond managers have commented on the liquidity crunch in the bond market, but tend to see the current conditions as an opportunity to find value rather than warning of liquidity issues.
Artemis Corporate Bond manager Stephen Snowden said: “The initial [bond] sell-off was indiscriminate and turned into the worst liquidity crunch in credit markets I’ve seen in my 25 years as an investor.”
However, after the Federal Reserve started buying up corporate bonds, Snowdon was able to sell of riskier bonds to buy up higher quality replacements “without a big drop in yield”.
Gregoire Mivelaz, co-manager of GAM Star Credit Opportunities GBP, said: “Prices have fallen so much that valuations now suggest one of the strongest buy signals for a number of years – bonds could even be the bargain of the century.”
And BlackRock Corporate Bond manager Ben Edwards added: “It’s probably the best value investment grade market I have seen in my career.”
When asked about the ideal bond fund size, Buckhurst said around £200m to £300m was preferable, adding that Vermeer Partners is actively turned off by larger corporate bond funds.
“If we see two fund managers, equally qualified and good, we would prefer to go with the manager with the smaller fund. It’s the opposite of big is beautiful,” he noted.
One fund he highlighted as being attractive was SVS Church House Investment Grade Fixed Interest. He cited a stable investor base as this means the fund is unlikely to see mass redemptions and, more to Buckhurst’s point, is £352m in size.
Performance of fund vs sector over 5yrs
Source: FE Analytics
The fund describes itself as “a 100 per cent investment grade bond fund”, which will always hold at least one-quarter of the portfolio in AAA-rated debt as a further quality control. Manager Jeremy Wharton runs a diverse portfolio of more than 100 holdings and focuses on “high-quality issuance” to limit volatility.
SVS Church House Investment Grade Fixed Interest has an ongoing charges figure (OCF) of 0.83 per cent and a yield of 2.21 per cent.