BLOG: A crisis in the making?
Something is amiss in the corporate bond market. In essence, corporate bonds are relatively straightforward: they are loans made to companies. The company goes out to investors and says something along the lines of ‘if you lend me £10,000, I will pay you 4 per cent interest for 10 years with your money back at the end’. Companies that are higher risk generally have to pay a higher interest rate to attract buyers and investors usually get a higher rate for tying up money for longer.
Usually, the only risk to investors is that a company defaults and doesn’t pay back its creditors and this tends only to happen to a handful of companies. However, most corporate bond collective funds buy and sell in the secondary market, and here they are vulnerable to greater losses.
The fund managers could simply hold the bond to maturity, but most bond funds offer their investors the option to redeem, should they choose, every day. This means they have to go into the market and find a buyer to meet those bond redemptions. And this is where the problem lies.
Those buyers have started to dry up. Most corporate bond funds will hold some cash to meet redemptions, but once they have used that up, they need to start selling their portfolio holdings. If they can’t find buyers, they can’t meet redemptions.
This problem has precedents: during the financial crisis, commercial property funds were forced to impose exit penalties to prevent them having to do a fire sale of assets to meet redemptions. The worry is that corporate bond fund managers could be forced to do the same.
Aberdeen last week said it was introducing a $500bn liquidity buffer to protect in the case of a crisis in the corporate bond markets. This seems a responsible response to the problem and it would be good if other fund managers followed suit.
Research firm Fundhouse has warned investors faced potentially huge losses on illiquid holdings if the recent sell-off in fixed income accelerates. While those investors that can ride out the storm may come out unscathed, it is still likely to be an uncomfortable period, even for those – rare – investors that are happy committing to long periods without access to their funds.
So is this a crisis in the making? It might be. Investors should certainly be alert to the risks and decide whether they still want to be holding corporate bonds in this environment.