Rory Maguire, managing director of Fundhouse, explains how fund ratings agencies are responding to concerns about liquidity in the high-yield bond market
Our cousins, the credit ratings agencies, are being fined for positive credit ratings they gave leading up to the financial crisis, when those ratings turned out to be wrong and driven by a commercial agenda. Today, we think a similar asset/liability mismatch is sitting inside some daily-traded bond funds, where clients can access their money daily, but the funds cannot liquidate their bonds nearly as quickly.
So far, while clients pour money into bond funds, this has not been tested – but the tide seems to be turning. For this reason, it is probably a definitive moment for fund-raters with all parties – our clients, the regulator and the fund managers. Could we be next if our positive ratings end up being dead wrong?
|"Liquidity is the price haircut a seller of a bond takes because there are far more sellers than buyers in the market at that time." |
Let’s be honest here – the issue of bond illiquidity is not an unknown unknown. It has been all but telegraphed to us, even by the fund managers themselves. Are we too cosy with the fund managers, creating a state of wishful blindness with our potentially overly rosy ratings, impacted by a commercial agenda too? These are big questions.
We would argue that funds that have wide-ranging investment choices, such as strategic bond and multi-asset income offerings – may well be sitting on some illiquid high-yield bond positions that could be past their sell-by dates.
And these positions represent an active investment choice – flexible funds have a choice what they buy and, therefore, should be held more to account for owning these investments than, say, a fund that can only invest in high-yield bonds.
In this article, we will discuss the four main arguments we hear from fund managers in defending their investment in these instruments – and share our views on each – before concluding with how we aim to respond.
Definition of 'liquidity'
Before doing so, however, it is instructive to put forward a definition of ‘bond liquidity’. M&G offered one recently, saying: “We define liquidity as ‘the cost of immediacy of trading’, that is, the ability to execute trades at a reasonable market level.” Put another way, we would say it is the price haircut a seller of a bond takes because there are far more sellers than buyers in the market at that time.
So what are our concerns with high-yield bonds? Principally, there are four – the first of which is that, because the fixed income sector has received substantial net inflows, the market has had more buyers than sellers for a long time now. Outflows seem to be starting and this may turn high-yield bond owners into a collective of forced sellers – something not fully tested in the market since the financial crisis.
A second concern is that the providers of liquidity are no longer the banks, as was the case pre-crisis, when they were the engine room of liquidity. Today, they hold around 20% of the bonds they used to and – over the period – the number of bond issuances has increased materially.
This creates a double-up effect – the market is getting bigger and liquidity is reducing. Now, when large volumes of bonds are sold by one fund manager, it is almost certainly a rival fund manager that buys them. What happens to the prices if they are both sellers, though?
Third, clients can withdraw their savings from these investment funds in 24 hours. Yet, the high-yield bond positions need a lot more time to be sold down if the owner is price-sensitive. There is, in our view, a significant mismatch in asset and liability profile that could occur.
Finally, there is a heightened reputational issue. Bond funds, for example, are already seen as ‘the shadow banking system’ – a dangerous tag that suggests they are important to broader economic stability.
It also implies that the main lenders to markets are mutual funds and that such funds are being used more like bank deposit accounts, by their clients, than long-term investments (that can suffer large capital downside). Bond fund managers are also receiving record pay, another potential target. Are we setting ourselves up for a reputational hit?
During the financial crisis, relative to Treasuries and investment-grade debt, high-yield lost almost 35% in aggregate, showing how much more sensitive the asset class can be to market sentiment. So, is this a similar market to 2007/08? When we discuss this question – and other liquidity concerns – with fund managers, they will tend to put forward the following main arguments:
* There was more leverage in 2007/08: This is true – in theory. We certainly see far less leverage today and therefore, in theory, a limited multiplier effect of downside if bond investors head for the exit together. But, because history tends to rhyme, not repeat itself, we suggest that leverage may be in a different form.
The bond funds have daily liquidity, yet when we speak to managers, they struggle to sell modest to high volumes of high-yield bonds (without a price haircut), unless they have months to do it. It is not a surprise with more bonds in issue and with fewer market-makers (the banks are marginal players now). Perhaps ask your high-yield or strategic bond manager this – if you had £500m of high-yield bonds to sell quickly, how long would it take if you were sensitive to receiving the right price?
So, there is a potential for an asset/liability mismatch, which can create the effect of leverage, and a multiplier effect is – arguably – waiting to happen, because fund withdrawals happen en masse and tend to gain momentum quickly.
* Pimco had outflows and the market coped fine: We do not fully agree with this. Pimco’s outflows were compensated for by net inflows in the industry. So, the bonds simply shifted to other fund managers who were net buyers. It is worth repeating – the market has not been tested in a ‘net outflow’ environment, when most asset managers are net sellers. This would, in our view, have made the Pimco outcome different.
* Bond illiquidity is a buying opportunity: Of course it is and it is a fabulous one. You want to be the buyer, not the seller, when the market has too many sellers. But this has been an easy stance to take when these funds continue to have inflows and cash to spend. The challenge is that these less liquid instruments are widely owned and we see few keeping their powder dry in anticipation of the opportunity. Otherwise, why own the very investments that may provide others with this opportunity, rather than themselves?
* Some of the portfolio is liquid – for example, sovereign bonds and cash: Again, this can be true but needs investigation. The liquid resources – cash and sovereigns – are finite and, should outflows occur on the same basis as we have seen inflows, this could challenge the funds.
Perhaps instructively, in the recent market turbulence, we noticed high-yield bonds held up well, relative to investment-grade bonds, which was a surprise. Is this because participants are only selling what is liquid, rather than some of their high-yield positions?
If we look at one of the largest funds, M&G Optimal Income, it grew from £329m at the end of 2008 to £24bn by the end of 2014, a period of 72 months. This represents an average increase in net asset value of £330m each month. What happens if these sorts of industry inflows start reversing? Perhaps nothing material, because M&G are sensitive to liquidity. But, we need to test them and their peers thoroughly, nonetheless.
In conclusion, it is sensible to engage with fund managers on the issue of bond illiquidity and understand whether their funds have any asset/liability mismatches – because of the illiquidity of what they own, versus the daily liquidity of the fund.
The answer is always going to be a matter of judgement – but all we can do, as fund-raters, is err on the side of caution and place funds under review when we see moments like this in the market (in fact, we arguably could have done it sooner). This is what we have now done and we expect new ratings out on a few funds following this process.
Fundhouse provides fund research, ratings and portfolio construction advice to financial advisers and institutions. To find out more, click here
How should fund ratings agencies respond to the current environment and associated concerns?
* We engage with the managers: We are respectful of them being the experts but this does mean we need to ask the tough questions.
* We must be brave at these times: We need to be willing to say when we are concerned – and go on record, by telling our clients.
* Watch out for yield targets: To use an example we discussed in the last Hub News (see article below), multi-asset funds that aim to yield 5%, when most of the bond market yields under 3%, tells you they are probably investing in high-yield. Clients need to decide whether such choices are because they are sensible investments or because they are reaching for yield. The latter could create a permanent loss of capital and, as ratings agencies, we need to respond.
* Fund size matters: All else being equal, should liquidity contract, you would rather be selling smaller than larger volumes. Selling £40m of a high-yield bond issue is far harder, more prone to a price haircut and takes longer than selling £4m. As such, we are more concerned about the larger funds.
* Stock selection matters: Again, the larger a fund, the greater the number of investments, indicating they can no longer be as discerning with what they buy because they keep reaching their limits on what they already own. Fund size, again, is important here.
Beware the income overreach
Rory Maguire, managing director of Fundhouse, explains why he and his firm are monitoring multi-asset income funds so closely
Although we do rate some multi-asset income funds well, we have raised the same concern with each of their managers. It is that the income expectation always seems to settle at around 5% – the implication being their fund needs to offer a 5% income yield, on average across the fund, to be competitive with its peers. In a world where most bonds are yielding well under 5%, this seems an increasingly tough and risky deliverable.
But history is important here because these income targets were often set when bond yields were a lot higher – just remember how, before the financial crisis, yields looked a lot different than they do today. If you were a multi-asset income fund manager in late 2007, you had a far wider opportunity set. Cash rates were around 5% and corporate bond yields around 6%. The UK 10-year gilt was above 4% and you could dip into high yield at around 9%.
|"Is a multi-asset manager reaching for yield or would they drop their yield target to protect capital through better portfolio diversification." |
To extend this point, the BlackRock Investment Institute recently showed that, between 1999 and 2008, more than half the world’s bonds yielded above 4%. Today that number is below 20% and is clustered in emerging market debt and global high yield. Simplistically, it is easy to see how, in late 2007, a multi-asset income manager could comfortably build a diversified portfolio with a 5% yield target – and probably do it with quite a healthy exposure to investment grade bonds.
Roll the clock forward to today, however, and we are nervous. It is noticeable how increasingly narrow the opportunity set has become. Cash, as we know, delivers almost no yield now. We also find UK 10-year gilts at below 2% – raising the question as to whether they now represent ‘return-free risk’ rather than risk-free return. In fact the ‘1% club’ is now substantial – most developed market 10-year bonds yield below 2% – and many below 1%. We also find corporate bonds around 3% to 4% while global property stocks (Reits) are also under 4%. Healthy yields are rare – some might say very rare.
What does this mean for the multi-asset income manager who needs to average a 5% yield across the fund? The obvious point is that the yields they need are no longer readily available within those assets with a higher degree of capital protection (cash, sovereigns and investment grade corporates).
They therefore have to look elsewhere, often towards those that are traditionally more risky (high yield bonds and emerging market debt). They may also need to be more creative and focus on less traditional areas, such as infrastructure, loans, property debt and collateralised loan obligations – and these tend to be less liquid.
We would also be concerned that diversification becomes increasingly difficult in such a world. Take corporate bonds – they offer exceptional equity diversification, whereas high yield bonds tend to add to equity risk.
We are also starting to see signs that some managers could be starting to swap capital for income. As an example, we find various call option strategies in place today, where the manager is forgoing capital upside in exchange for income from call option premiums. These are, to the more sceptical investor, potential signs of income being manufactured.
Are we suggesting multi-asset income funds are becoming more risky? Naturally, that will depend on the one you choose but, in the short run, the answer is yes. With yields at these low levels, one has to assume some compromises are likely being made – to bond quality and perhaps liquidity. Their ability to diversify is also being challenged, which can cause an increase in equity-type return profiles.
We should also add that, if yields stay lower for longer, the demand for income will continue to outpace supply – and a multi-asset team, in theory, has all the tools to work around this problem. Since they should not be beholden to any one asset class to deliver yield, they are a core part of the income-generating fund options on the market.
But, caveat emptor is the order of the day. When rating a multi-asset income manager, we spend a substantial amount of time probing the manager on their attachment to a yield target. Are they reaching for yield or would they drop their yield target to protect capital through better portfolio diversification? We think yield targets need to drop in order to avoid the fund managers overreaching for income. But, so far, these yield targets remain.
Fundhouse provides fund research, ratings and portfolio construction advice to financial advisers and institutions. To find out more, click here