Comment: Stampede into bonds may have consequences

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WHEN a financial market trend is firmly lodged as unchallengeable wisdom, no number of warning flares seem to make much difference – for a time.

In recent months, several warnings have been fired across the bows of the giant corporate bond funds. And there are signs retail investors may now be sitting up and taking notice.

Over the past decade, corporate bond funds have become enormously popular. Between 2002 and 2008, fixed interest funds under management rose from £30.6 billion – 15 per cent of the Investment Management Association total – to £75.4bn, or 19.3 per cent. But with the onset of the financial crisis and the plunge in equity markets, the popularity of bond funds turned into a stampede. Between 2008 and 2011, fixed interest funds ballooned to £113bn.

This stampede has been reinforced by the continuing volatility of equity markets, concern over dismal economic prospects stretching years ahead – and warnings from industry regulators that retail investors and fund management companies should hold more of their portfolios in assets deemed less vulnerable to economic shocks. The result is that some bond funds have become enormous – the M&G Corporate Bond fund alone is now a massive £6.5bn.

This has brought big problems for the sector. Two are now critical. Firstly, as interest rates on cash deposits have remained at ultra-low levels, investor inflows into fixed-interest funds have grown. But the bigger the fund, the more difficult it is for managers to match the income and performance they achieved in previous years. The second is that observers worry ­liquidity in the sector could dry up and pull down performance, with the attendant risk of trapping investors in poorly performing funds.

Warning number one came in July when M&G urged senior financial advisers not to put any more of their clients’ money into its bond funds for the time being. The move came hard on the heels of a letter from the Financial Services Authority to corporate bond fund managers asking for a review of liquidity in the sector and whether there was a risk that investors could be denied access to their money in the event of a redemption rush.

The FSA letter and M&G warning would have been disconcerting for the tens of thousands of investors who switched into bond funds for “safety first” reasons and who have poured in almost £10bn in the past two years. Ironically, the risk of a liquidity crunch may have been exacerbated as a result of tightening regulatory requirements worldwide.

The FSA letter read: “We understand that the liquidity of many of the instruments in which such funds invest may be sufficiently low to make large trades difficult without material trading costs.

“Concerns have been raised with us that market liquidity has the potential to be impacted further as a result of the implementation of future global regulations. The market for these funds has been strong in recent years, and we wish to understand the extent to which a reversal of this trend could create risks for investors.”

The reduced liquidity is caused in part by investment banks cutting back on capital allocation to finance corporate bond trades. Owing to regulation and reduced cashflow, investment banks have just a quarter of the cash they had for trades, making it harder for managers to sell bonds in the market.

Now a further warning has come from an industry leader. Stephen Snowden, who manages three bond funds at Kames, told website FE Trustnet in an interview last week that investors should be extremely wary of liquidity issues, particularly among funds that have experienced a sharp influx of cash in the last five years.

“The time for denial is gone,” he said. “We have to accept liquidity is challenging and that trend is very much going to get worse. Market liquidity has disappeared and may well be gone for a long time. It’s not that this is a temporary period of indigestion and then things will go back to normal.”

Swiss investment bank UBS recently announced it would be cutting its fixed income operations. “UBS is a cornerstone of market-making fixed income,” said Snowden. “For them to wind down is a development nobody wants.”

There are 111 funds in the IMA global bond sector and a further 86 funds in the sterling fixed income category. These have mushroomed as investors have pulled away from highly volatile equity funds during the financial crisis and its aftermath. The trend became so marked – particularly with pension fund asset allocation swinging in favour of bonds – that some commentators have talked of “the death of the cult of equity”.

However, there have been signs in recent months of investors returning to equity funds, with a notable pick-up in net sales. This trend is likely to be reinforced by the improved performance of stock markets in November and early December. Were investors to take heed of concerns in the corporate bond sector, this could result in a further swing towards equity funds in the opening months of 2013.