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Room to manoeuvre

Roger WebbMore flexible and diversified mandates that can use all the investment tools available should provide bond investors with some comfort against current liquidity risks, says Roger Webb

Since the financial crisis, asset managers have had to adapt to a new investment landscape in which it has become increasingly hard to access liquidity. Government bond yields have fallen to ultra-low or negative levels, exacerbating the “hunt for yield” and managers have had to consider more flexible, diversified mandates;

  • Banks face more demanding capital requirements that have forced them to improve the quality of their capital bases
  • The corporate bond market is dealing with the consequences of central banks’ ultra-loose monetary policies
  • Intensifying demand for fixed-income assets and abnormal central bank policies have left investors wondering what will happen when policymakers finally change direction

There has been a lot of mention of the phrase ‘liquidity crunch’ in the media of late – and, by liquidity, we mean the ease with which an investor can buy or sell a bond in the marketplace without moving its price. Little wonder. Accessing liquidity is challenging at the moment in the corporate bond market and has been extreme since the global financial crisis. This situation is unlikely to change – and that means the asset management community is having to adapt to the new investment landscape.

As a direct consequence of the crisis, banking regulators globally have sensibly introduced tougher capital requirements for the banks in their jurisdictions. These banks – which act as market-makers for buyers and sellers of bonds – have been required to add to and improve the quality of their capital bases.

In order to trade bonds, the same banks have to put more of their own capital at risk. Naturally, this has reduced their desire to act as intermediaries, and the knock-on effect means it is now much more difficult for investors to trade corporate debt.

The ultra-loose monetary policies pursued by the major central banks – the US Federal Reserve, the Bank of England and the European Central Bank – have had a number of effects and some of these have resulted in consequences for the corporate bond market.

The fact government bond yields are at ultra-low levels – and have veered into negative territory in sizeable pockets of Europe – has triggered a ‘hunt for yield’. This has led to a big upsurge in demand for credit and a simultaneous tightening of risk premiums (spreads).

“Many strategic bond funds have lost their flexible nature due to the growing popularity of the asset class.”

Activity is often focused on the primary market, with the secondary market inconsistent at best due to liquidity problems. Robust levels of new issuance are likely to continue in all the major currencies. New deals are often significantly oversubscribed, but offer investors a chance to add exposure to names they understand … and at prices that suit. Recently, the Bank for International Settlements pointed out that liquidity problems have grown because trading volumes have not kept pace with this surge in debt issuance. While this is true, it has probably had less of an impact than the shrinking bank balance sheet issue. 

Greater demand for fixed income assets like corporate bonds, influenced by monetary policy action, presents us with the question – what happens when policy measures cease or reverse? If everyone looked to exit the asset class together there would be some problems. A lack of depth in liquidity has always been evident in corporate bond markets – as we saw from price action during the crisis. Such price moves could be severe, given the ever smaller balance sheets of our counterparties. Even a marginal seller could trigger some big moves as potential buyers step further back.

What does this mean for investors in bonds? In the current environment, not all that much, as the credit markets seem relatively attractive and benign. We do not think there is a ‘great rotation’ out of bonds at the moment, but we do remain aware of the risks and we believe we need to be paid a premium for illiquidity. We also need to shape our businesses appropriately. It is harder to justify short-term high performance targets in large corporate bond funds where illiquidity could restrict the manager’s ability to reposition the fund.

In recent years, the Sterling Strategic Bond sector has increased hugely in popularity. At the end of July 2015, it accounted for more than £32bn of UK funds under management. That is almost twice as large as for the UK Gilt sector.

The popularity of strategic bonds is understandable – a bond fund with increased diversification, more flexibility and greater agility, handled by a highly skilled fund manager and without benchmark bias is an appealing prospect. However, many strategic bond funds have lost their flexible nature due to the growing popularity of the asset class. In recent years, there has been a surge in the number of strategic bond funds with assets under management in excess of £1bn, with some eight funds exceeding this figure by mid-2015.

Aberdeen Strategic Bond Fund’s modest size allows it to navigate the markets in a nimble fashion and it is well equipped to respond to external events efficiently. It can exploit opportunities presented by unexpected market themes, and it can adapt to difficult macroeconomic conditions by exiting or entering holdings quickly. In contrast, funds with assets under management of more than £1bn can potentially suffer – simply because it is typically harder to trade in large size.

That said, the majority of clients still invest for the long term and can tolerate mark-to-market volatility. This has been illustrated by a growth in ‘buy and maintain’ corporate bond mandates, where liquidity is less vital but management of credit risk is still paramount. We have also seen a gradual move from single-currency to multi-currency offerings and single bond asset class to multi-asset bonds, both of which broaden the pool of liquid assets.

Those who cannot invest with a long-term horizon, however, should consider more dynamic approaches to bond allocations that would enable managers to manoeuvre when markets become more challenging. More flexible and diversified mandates that can use all the investment tools available will definitely provide investors with some comfort against the liquidity risks. We believe Aberdeen Strategic Bond Fund ticks all the right boxes.

Roger Webb is fund manager on the Aberdeen Strategic Bond Fund. For more information on the Aberdeen Strategic Bond Fund, click here

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