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“Firms and regulators should be alert to these developments, including their consequences for investment funds that offer daily liquidity while investing in securities that only appear liquid…

…the possibility of sharp, unpredictable changes in market liquidity poses a clear risk to financial stability, particularly when some market participants take liquidity for granted and crowd into trades in anticipation of central bank action.” Mark Carney, Governor of the Bank of England at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House, London, 10 June 2015.

“S&P reaches $1.5 billion deal with U.S., states over crisis-era ratings… The settlement comes after more than two years of litigation as S&P tried to beat back allegations that it issued overly rosy ratings in order to win more business.” Reuters 3 February 2015.

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 that 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? 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 cozy 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.

In this article, we suggest that funds that have wide ranging investment choices – like strategic bond funds and multi asset income funds – 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 note, we discuss the four main arguments we hear by fund managers in defending their investment in these instruments and we share our views on each and then conclude with how we aim to respond.

It is instructive to put forward a definition of “bond liquidity”. M&G offered one last week, 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.

What are our concerns with high yield bonds? There are four, mostly:

– The market has had more buyers than sellers for a long time now, because the fixed income sector has received substantial net inflows. The reverse of this has not been tested properly. 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.

– 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?

– 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.

– There is a heightened reputational issue – for Carney to mention it, tells us something. Bond funds, for example, are already seen as “the shadow banking system”, a dangerous tag and it suggests they are important to broader economic stability. The tag 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?

Below is a graph of USD returns from Treasuries, Investment Grade and High Yield bonds during the financial crisis. High yield lost almost 35%, relative to the other asset classes, in aggregate, showing how much more sensitive they can be to market sentiment. So, is this a similar market to 2007/8?

When we discuss this question with fund managers (and other liquidity concerns) they put forward the following main arguments:

1. There was more leverage in 2007/8.

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 hair cut), unless they have months to do it. It’s 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: 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: a multiplier effect is (arguably) waiting to happen, because fund withdrawals happen en masse and tend to gain momentum quickly.

2. PIMCO had outflows and the market coped fine

BlackRock’s vice-chairman Barbara Novick (source Financial Times, March 2015): “The recent example of outflows from PIMCO’s Total Return strategy following the resignation announcement of lead portfolio manager Bill Gross is a good example of the ability to transition large amounts of assets from one manager to another without market disruption.”

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. The market has not been tested in a “net outflow” environment, when most asset managers are net sellers. This would have made the PIMCO outcome different, in our view.

3. Bond illiquidity is a buying opportunity

Of course it is and it’s 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: 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?

4. Some of the portfolio is liquid, like Sovereign Bonds, Cash and CDS

This is 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 that high yield bonds held up well, relative to investment grade bonds (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, the M&G Optimal Income Fund: 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. For the record, we have placed the M&G Optimal Income Fund under review (it was rated Tier 2).

We should also point out that CDS returns are not always the same as the underlying bond returns – as we saw in the GFC. So, even if they end up being more liquid, do they deliver high yield bond returns that are the same as the underlying instruments? During the GFC, this was not the case.

How do we respond?

• 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. Multi Asset Funds, for example, that aim to yield 5%, when most of the bond market yields under 3%, tells you something: 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, you would rather be selling smaller volumes than larger volumes, should liquidity contract. Selling £40m of a high yield bond issue is far harder, more prone to a price hair cut and takes longer than selling £4m. Therefore, we are more concerned about the larger funds.
• Stock selection matters. Again, the larger a fund, the greater the number of investments, indicating that 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.

In Conclusion: We think 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 judgment – 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 done and we expect new ratings out on a few funds following this process.

Rory Maguire, CEO Fundhouse, June 2015