Are bond funds set for significant spike in outflows?
While the FSA has taken steps to assess corporate bond fund liquidity in the event retail investors all move for the exit at once, managers said the biggest risks to bond markets lie much further in the future.
They said short-term sentiment for bonds remains supportive given the general lack of risk appetite. John Pattullo, manager of the £1bn Henderson Strategic Bond fund, said the big threat to corporate bond markets would be a resurgent economy.
However, with inflation falling and the economy shrinking, and with measures from the Bank of England – chiefly quantitative easing – failing to boost demand, it seems unlikely this will materialise soon.
“The biggest risk to bond markets is the economy recovering and central bank policy working, with money expansion creating demand and then leading to inflation,” he said.
“I am sure it will happen in five or ten years, but on a two-year view, it is not a worry. Indeed, the big theme over the last month has been even lower, for even longer.”
Bond yields have come in dramatically thanks to QE, with gilt yields at record lows and corporates seeing spreads tighten significantly.
Richard Hodges (pictured), manager of the £1.5bn Legal & General Dynamic Bond Trust, noted how fixed income investors have been ‘coerced’ into higher yielding and lower quality bonds in both the sovereign and corporate space.
“We are in an environment whereby the only possible chance to achieve an acceptable level of income in an environment of lower-for-longer interest rates is to carry the burden of risk upon our shoulders,” he said.
“The consequences of this are that we now have to accept a much increased probability of default and the potential of an increased ‘bail-in’ in the event of default or in an attempt to restructure debt.”
QE was designed for just this purpose, but as Pattullo noted, investors are not playing ball, instead buying the least risky assets even though it means accepting lower and lower returns.
Hodges said the policy will ultimately have to change, but in the meantime, it means assets like cash could not meet investor demands, leaving them with few options.
“Even in an environment of much reduced liquidity, it is impossible to meet an end investor’s reasonable expectations with regard to income by investing in cash funds.
“We will have to see either a policy change by the Bank of England or a change in the UK’s ‘safe haven’ status.”
Meanwhile, equities are more likely to face a correction than a sustained rise, with the widely-followed Credit Suisse Global Risk Appetite index currently showing investor sentiment is nearer ‘panic’ than ‘euphoria’.
With equities therefore unlikely to see huge inflows unless the economic outlook improves, and cash paying next to nothing, it seems bonds are well placed to continue to be the asset class of choice.
Managers are, however, moving to protect portfolios from the liquidity squeeze playing out. There is a near industry standard cash buffer now being held by most corporate and strategic bond funds, in part to help them mitigate liquidity problems.
Hodges said liquidity is a key concern for bond fund managers now, and needs to be tackled.
“Anyone telling you there is no problem with liquidity is lying. The lack of liquidity is staggeringly bad, and I am in de-risking mode,” he said. “Other investors have been de-risking relative to benchmarks, and I am holding assets such as short-dated gilts specifically for liquidity purposes.”